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Option Payoff profiles – Calls and Puts

Option Payoff profiles for Calls and Puts

Compare this to the pay off profile for an option contract.  Unlike a forward, there is only a limited downside with option contracts. An option gives its owner the right to exercise but not the obligation to perform if the exercise would result in a loss. For that additional protection there is a price and it is charged upfront as a premium. 

Payoff Profiles Calls And Puts

Once again, a Call option gives it owner the right to buy the underlying at a price and time agreed upon the date of purchase of the option contract. A Put option gives it owner the right to sell the underlying at a price and time agreed upon the date of purchase of the option contract.

Payoff Profiles Calls And Puts 1

A Call option is a bullish instrument, which is purchased when you expect prices to rise and want to benefit from that rise. As you can see in the payoff diagram above the value of call option increases when prices rise but the downside when prices fall is limited to the premium lost when the option is not exercised.

Unlike the buyer of a call, the seller of a call is obligated to perform. His upside is the premium that he retains when the call option is not exercised; his downside is the direct inverse of the payoff profile of the buyer of the call.

Payoff Profiles Calls And Puts 2

The same rules hold true for the buyer and seller of the put option as shown in the next two diagrams.

Payoff Profiles Calls And Puts 3

Payoff Profiles Calls And Puts 4

The following table summarizes and reviews the above concepts.

ProductPositionTranslationDownside
CallLongBought – Owns the optionPremium paid
CallShortSold – Wrote the optionIf the option is exercised, the difference between Market price and Strike price
PutLongBought – Owns the optionPremium paid
PutShortSold – Wrote the optionIf the option is exercised, the difference between Strike price and Market price
ForwardLongBought the underlyingThe difference between Forward price and Market price, if prices decline
ForwardShortSold the underlyingThe difference between Market price and forward price, if prices rise

 

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