Options Payoffs
The main characteristic
of options results in a non-linear payoff for options. It means that the losses
for the buyer of an option are limited; however the profits are potentially
unlimited.
For a writer, the
payoff is exactly the opposite. Profits are limited to the option premium; and
losses are potentially unlimited. These non-linear payoffs are fascinating as
they lend themselves to be used to generate various payoffs by using
combinations of options and the underlying.
Payoff profile for buyer of call
options: Long call
A call option gives
the buyer the right to buy the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on
the spot price of the underlying. If upon expiration, the spot price exceeds
the strike price, he makes a profit. Higher the spot price, more is the profit.
If the spot price of the underlying is less than the strike price, the option
expires un-exercised. The loss in this case is the premium paid for buying the
option.
For eg: If upon
expiration, Nifty closes above the strike price the buyer would exercise his
option and profit to the extent of the difference between the Nifty-close and
the strike price. The profits possible on this option are potentially
unlimited. However if Nifty falls below the strike price, he lets the option
expire. The losses are limited to the extent of the premium paid for buying the
option.
Payoff profile for writer of call
options: Short call
A call option gives
the buyer the right to buy the underlying asset at the strike price specified
in the option.
For selling the
option, the writer of the option charges a premium. The profit/loss that the
buyer makes on the option depends on the spot price of the underlying. Whatever
is the buyer’s profit is the seller’s loss. If upon expiration, the spot price
exceeds the strike price, the buyer will exercise the option on the writer.
If the spot Nifty
rises, the call option is in-the-money and the writer starts making losses.
Higher the spot
price, more are the losses.
If upon expiration,
Nifty closes above the strike price, the buyer would exercise his option on the
writer who would suffer a loss to the extent of the difference between the
Nifty-close and the strike price. The loss that can be incurred by the writer
of the option is potentially unlimited, whereas the maximum profit is limited
to the extent of the up-front option premium charged by him.
If upon expiration
the spot price of the underlying is less than the strike price, the buyer lets
his option expire unexercised and the writer gets to keep the premium.
Payoff profile for buyer of put
options: Long put
A put option gives
the buyer the right to sell the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on
the spot price of the underlying. If upon expiration, the spot price is below
the strike price, there is a profit. Lower the spot price more is the profit.
If the spot price of the underlying is higher than the strike price, the option
expires un-exercised. His loss in this case is the premium he paid for buying
the option.
If the spot Nifty
falls, the put option is in-the-money. If upon expiration, Nifty closes below
the strike price, the buyer would exercise his option and profit to the extent
of the difference between the strike price and Nifty-close. The profits
possible on this option can be as high as the strike price. However if Nifty
rises above the strike price, the option expires worthless. The losses are
limited to the extent of the premium paid for buying the option.
Payoff profile for writer of put
options: Short put
A put option gives
the buyer the right to sell the underlying asset at the strike price specified
in the option. For selling the option, the writer of the option charges a
premium. The profit/loss that the buyer makes on the option depends on the spot
price of the underlying. Whatever is the buyer’s profit is the seller’s loss.
If upon expiration, the spot price happens to be below the strike price, the
buyer will exercise the option on the writer. If upon expiration the spot price
of the underlying is more than the strike price, the buyer lets his option go
un-exercised and the writer gets to keep the premium.
As the spot Nifty
falls, the put option is in-the-money and the writer starts making losses. If
upon expiration, Nifty closes below the strike price, the buyer would exercise
his option on the writer who would suffer a loss to the extent of the
difference between the strike price and Nifty-close. The loss that can be
incurred by the writer of the option is a maximum extent of the strike price
(Since the worst that can happen is that the asset price can fall to zero)
whereas the maximum profit is limited to the extent of the up-front option premium
charged by him.
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