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What is Option Payoff?
The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited, however, the profits are potentially unlimited. The writer of an option gets paid the premium.
The payoff from the option writer is exactly opposite to that of the option buyer. His profits are limited to the option premium, however, his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used for generating various complex payoffs using combinations of options and the underlying asset. We look here at the four basic payoffs.
Payoff 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.
The higher the spot price, more is the more profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 6.1 gives the payoff for the buyer of a three-month call option on gold (often referred to as a long call) with a strike of Rs. 7000 per 10 gms, bought at a premium of Rs. 500.
The figure shows the profits/losses for the buyer of a three-month call option on gold at a strike of Rs. 7000 per 10 gms. As can be seen, as the prices of gold rise in the spot market, the call option becomes in the money.
If upon expiration, gold trades above the strike of Rs. 7000, the buyer would exercise his option and profit to the extent of the difference between the spot gold- close and the strike price. The profits possible on this option are potentially unlimited. However, if the price of gold falls below the strike of Rs. 7000, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.
Payoff for Buyer of Put Options: Long Put
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 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. Hence as the spot price increases the writer of the option starts making losses. The higher the spot price, the more the loss he makes.
If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 6.2 gives the payoff for the writer of a three-month call option on gold (often referred to as short call) with a strike of Rs. 7000 per 10 gms, sold at a premium of Rs. 500.
Payoff 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, he makes a profit.
The lower the spot price, more is the more profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. The figure gives the payoff for the buyer of a three-month put option (often referred to as long put) with a strike of 2250 bought at a premium of 61.70.
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 the buyer’s profit is the seller’s loss. If upon expiration, the spot price happens to the 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 expire un-exercised and the writer gets to keep the premium. The figure gives the payoff for the writer of a three-month put option (often referred to as short put) with a strike of 2250 sold at a premium of 61.70.
