How to Calculate Call Option Payoffs
Call option payoffs refers to the profit or
loss that an option buyer or seller makes on a trade. Remember that there are
three key variables to consider when pricing call options: strike price, expiry
date, and premium. These variables calculate payouts generated from call
options. There are two cases of call option payoffs.
Payoffs for call option buyers
Suppose
you buy an option to buy company ABC for a premium of RS2. The exercise price
of the options is RS50 and has an expiration date of November 30th. You will
break even on your investment when the ABCs share price reaches RS52, which is
the sum of the premium paid plus the share purchase price. Any increase above
this amount is considered a win. Therefore, if the ABCs stock price increases
in value, the payoffs is unlimited. What happens if ABCs share price falls
below RS50 by 30th November? Because your option contract is a right, not an
obligation, to purchase ABC stock, you may choose not to exercise it, which
means you are not buying ABCs stock. In this case, your losses are limited to
the premium you paid for the option.
Payoff = spot
price - strike price
Profit = payoff
- premium paid
Using the formula above, your
profit is RS3 if ABC's spot
price is RS55 on Nov. 30.
Payoff for call
option sellers
The
payoffs calculations for the seller of a call option are not very different. If
you sell an ABC options contract with the same strike price and expiration
date, you only gain if the price falls. Depending on whether your call is
covered or uncovered, your losses may be limited or unlimited. The latter case
occurs when you are forced to buy the underlying stock at spot prices (or
perhaps even more) if the option buyer exercises the contract. Your only source
of income (and profit) in this case is limited to the premium you receive when
the options contract expires.
The
formulas for calculating payoffs and profits are as follows:
Payoff = spot
price - strike price
Profit = payoff
+ premium
Using the formula above, your income is RS1 if ABC's spot price is RS47 on Nov. 30.
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