Options Risk Characteristics

    Option Risk Profile

    We went over the basics of puts and calls in our introduction to options.  Now, we want to build on that and cover the option risk characteristics of a call and put. 

    Option Risk Profile

    We went over the basics of puts and calls in our introduction to options.  Now, we want to build on that and cover the option risk characteristics of a call and put. 

    Long Call Risk Characteristics

    Let's cover the risk profile of a call first.  I believe examples in this section would be the best way to cover this topic.  We are going to start with a LONG CALL example. 

    Current Price of Stock$24.00
    Option Exercise Price$20.00
    Call Premium$5.25
    Months Till Expiration3

    In this scenario, we would be buying deep in the money calls for $5.25, $4 in intrinsic value and $1.25 for 3 months of time premium.  The buyer of this call option is anticipating that the underlying security will be higher than $25.25 ($20 exercise or strike price + $5.25 option premium) within 3 months of time.  Therefore, in our diagram below, the strike price is $20 while the breakeven price is $25.25.  As the stock moves above point b* or breakeven, the call buyer is in a profit position.  For example, assume the stock reaches $30 at expiration; the call buyer would be able to buy the stock at 10 point discount while only paying $5.25 for that option.

    Once the underlying security is above the strike price, the option will move penny for penny with the security.  The reward for the call buyer can be unlimited as the security can go as high as it wants to. 

    Long Call Risk Characteristics

    Short Call Risk Characteristics

    When someone is buying an option, there is obviously a seller on the other side who believes that the stock will not go above $25.25 within the next 3 months.  Let's now take a look at the option risk profile of an option writer.  For the sake of clarity, the term "write" refers to shorting or selling an option.  Using the same example from above, the writer of the option has received a premium of $5.25 and will continue to remain in a profit position as long as the stock does not move above $25.25.

    Shorting an option brings added risk, especially if the seller is "naked".  The term "naked option" refers to the idea that the seller of the stock does not own the underlying stock that may eventually end up being called away by the purchaser of the option.  Just like the naked put option, selling naked calls is a risky proposition and should be done only after much experience since there is no limit to the option based risk. 

    The most common use for selling a call is part of a common options strategy known as the covered call.  We will cover this strategy in far more detail, but the short story is that covered calls limit your downside exposure and add that extra bit of insurance and cushion to your long position. 

    Short Call Risk Characteristics

    Long Put Risk Characteristics

    Lets start with a new example for the put section:

    Current Price of Stock$40.00
    Option Exercise Price$40.00
    Put Premium$5.00
    Months Till Expiration3


    When initiating a long put option position, the option holder is looking to cover his/her downside risk in the event the stock takes a larger than expected hit.  Puts allow the put buyers the ability to force the writer of the option to buy the underlying stock at the strike price.

    You may be asking what the difference between selling a call and buying a put is.  They both limit your downside risk, right?  Yes, but there are two key differences.  Puts protect you against disastrous or rapid declines in a securities value; calls will only limit the downside up to the value of the premium you received for selling that call.  The second key difference lies in the fact that selling a call results in a net debit to your account balance while buying a put will result in a net credit, or a cash outlay.

    By going long the put option for $5 with a strike price of $40, the breakeven price would be ($40 + $5), or $45.  As the stock moves lower, the put buyer moves into a profit position, penny for penny.

    Long Put Risk Characteristics

     

    Short Put Risk Characteristics

    Finally, let's take a look at the short put risk chart.  When you write a put option, or go short, you are selling premium in anticipation that the stock will move higher and therefore you will be able to eat the entire option premium.  Alternatively, a potential buyer of a stock may want to get long a stock and will sell puts to do it.  Essentially, taking our example above, instead of buying the stock at $40 a share, the investor could short the put option for $5 and be forced to buy it at $40 if the stock moves lower at expiration.  The bet here is that the stock wont drop below $35 a share.  If the stock moves above $40 at expiration, the writer of the option would have made $5 per share as the option would never be exercised by the purchaser. 

    In our example below, the breakeven for this scenario would be ($40 - $5), or $35.  As the stock moves lower, the price of the put moves higher and this results in greater losses for the writer of the put. 

    Short Put Risk Characteristics

    Conclusion

    The concepts we discussed above are the basic profit/loss characteristics of put and calls.  Study these charts carefully and commit them to memory.  Once you master these basics, you will be able to more fully understand the options strategies that we will cover.

    Tim Ord
    Ord Oracle

    Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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