Introduction

Understanding the payoff function and calculating the potential profit or loss from an options position is essential for effective options trading. This chapter delves into the mechanics of the payoff function and guides you through the process of assessing your potential gains and losses when engaging in options trading.

Payoff Diagrams for Options

Options traders often use payoff diagrams, also known as profit and loss diagrams, to visualize the potential outcomes of their options positions at expiration. A payoff diagram plots the profit or loss on the y-axis and the underlying asset’s price on the x-axis. The shape of the diagram reveals how the position will perform under various scenarios.

For example, consider a long call option with a strike price of USD 50. As the underlying asset’s price increases beyond USD 50, the option’s payoff starts to rise, showing a potential unlimited profit. However, if the asset’s price remains below the strike price, the option’s payoff is limited to the premium paid.

Calculation of Profit and Loss

Calculating the profit or loss from an options position involves considering factors such as the option premium, strike price, and market price of the underlying asset. The profit/loss is determined by subtracting the initial investment (premium paid) from the difference between the market price and the strike price (adjusted for the type of option).

For instance, let’s assume you buy a call option with a premium of USD 3 and a strike price of USD 60. If the market price of the underlying asset rises to USD 70 at expiration, your profit would be (USD 70 - USD 60 - USD 3) = USD 7 per share. However, if the market price remains below the strike price, your loss would be limited to the premium of USD 3.