When investors purchase options, the risk graphs look much different than when purchasing stocks. The reason for this is because there is more capital at risk.
In the following example, the investor is purchasing a call option.
When an investor purchases a call option the risk graph looks like the picture below. An investor would purchase a call option for one of two reasons: 1) they are speculating that the underlying stock price is going to increase or 2) they want the right to buy the stock, but not the obligation. If the investor is speculating, they can profit from increases in the underlying stock price without having to spend a large amount of capital to purchase the stock. The most at risk with a call option is the premium paid.
If you recall from lesson 1.1, the owner of a call option has the right to purchase the underlying stock but not the obligation. Therefore, if the investor was bullish on this stock but didn't want to allocate the large amount of capital necessary to purchase it, the investor could simply purchase a call option. The strike price of the call option would allow the investor to buy 100 shares of the underlying stock at that price between now and expiration, no matter how high the stock price went.
Breakeven at expiration = Strike Price + Premium Paid
An investor purchases 1 December 45 call option for
$2.00.
Break even at expiration = 45 strike + $2.00 premium = $47
(if underlying stock price is less than break even at expiration,
the option contract would expire worthless.)
Payoff at expiration = Underlying Price - ( Strike Price + Premium Paid )
At expiration underlying stock price is $53.
Payoff at expiration = $53 - ( $47) = $6.00 payoff
The call buyer can now exercise the contract and buy the underlying
stock for $45 per share even though the market value of the stock is now
$53. The $2 premium that was originally paid must be factored in as an
expense of buying this right. (if underlying stock price is less
than break even price at expiration [$46.99 or less], it would not make
sense for the call buyer to exercise the contract because stock could be
purchased on the open market for less.)
In the next example, the investor is purchasing a put option.
When an investor purchases a put option the risk graph looks like the picture below. An investor would purchase a put option for one of two reasons: 1) they are speculating that the underlying stock price is going to decrease or 2) they want to hedge against stock they already own. If the investor is speculating, they can profit from decreases in the underlying stock price without having to short the stock and take on unlimited risk. The most at risk with a put option is the premium paid.
An investor can also hedge against stock they already own by purchasing put options. If you recall from lesson 1.1, the owner of a put option has the right to sell the underlying stock. Therefore, if the investor owned 100 shares of this stock and wanted to hedge against possible declines in the stock price, purchasing a put option would allow for that. The strike price of the put option would allow the investor to sell 100 shares of the underlying stock at that price between now and expiration, even if the stock price went to $1!
Breakeven at expiration = Strike Price - Premium Paid
An investor purchases 1 December 60 put option for
$1.00.
Break even at expiration = 60 strike - $1.00 premium = $59
(if underlying stock price is more than break even at expiration,
the option contract would expire worthless.)
Payoff at expiration = ( Strike Price - Premium ) - Underlying Price
At expiration underlying stock price is $55.
Payoff at expiration = ($59) - $55 = $4.00 payoff
The put buyer can now exercise the contract and sell the underlying
stock for $60 per share even though the market value of the stock is now
only $55. The $1 premium that was originally paid must be factored in
as an expense of buying this right. (if underlying stock price is
more than break even price at expiration [$59.01 or more], it would not
make sense for the put buyer to exercise the contract because stock
could be sold on the open market for more.)
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