option positions: buying a call option (long a call option), selling a call
option (short a call option), buying a put option (long a put option),
and selling a put option (short a put option). We will use stock options
in our example. The illustrations assume that each option position is
held to the expiration date and not exercised early. Also, to simplify the
illustrations, we assume that the underlying for each option is for 1
share of stock rather than 100 shares and we ignore transaction costs.
Buying Call Options
Assume that there is a call option on stock XYZ that expires in one
month and has a strike price of $100. The option price is $3. The profit
or loss will depend on the price of stock XYZ at the expiration date.
The buyer of a call option benefits if the price rises above the strike
price. If the price of stock XYZ is equal to $103, the buyer of this call
option breaks even. The maximum loss is the option price; there is a
profit if the stock price exceeds $103 at the expiration date.
It is worthwhile to compare the profit and loss profile of the call
option buyer with that of an investor taking a long position in one share
of stock XYZ. The payoff from the position depends on stock XYZ’s
price at the expiration date. An investor who takes a long position in
stock XYZ realizes a profit of $1 for every $1 increase in stock XYZ’s
price. As stock XYZ’s price falls, however, the investor loses, dollar for
dollar. If the price drops by more than $3, the long position in stock
XYZ results in a loss of more than $3. The long call position, in contrast,
limits the loss to only the option price of $3 but retains the upside
potential, which will be $3 less than for the long position in stock XYZ.
Writing Call Options
To illustrate the option seller’s, or writer’s, position, we use the same
call option we used to illustrate buying a call option. The profit/loss
profile at expiration of the short call position (that is, the position of the
call option writer) is the mirror image of the profit and loss profile of
the long call position (the position of the call option buyer). The profit
of the short call position for any given price for stock XYZ at the expiration
date is the same as the loss of the long call position. Conse-
quently, the maximum profit the short call position can produce is the
option price. The maximum loss is not limited because it is the highest
price reached by stock XYZ on or before the expiration date, less the
option price; this price can be indefinitely high.
Buying Put Options
To illustrate a long put option position, we assume a hypothetical put
option on one share of stock XYZ with one month to maturity and a
strike price of $100. Assume that the put option is selling for $2. The
profit/loss for this position at the expiration date depends on the market
price of stock XYZ. The buyer of a put option benefits if the price falls.
As with all long option positions, the loss is limited to the option
price. The profit potential, however, is substantial: the theoretical maximum
profit is generated if stock XYZ’s price falls to zero. Contrast this
profit potential with that of the buyer of a call option. The theoretical
maximum profit for a call buyer cannot be determined beforehand
because it depends on the highest price that can be reached by stock
XYZ before or at the option expiration date.
Writing Put Options
The profit/loss profile for a short put option is the mirror image of the
long put option. The maximum profit to be realized from this position is
the option price. The theoretical maximum loss can be substantial
should the price of the stock declines; if the price were to fall to zero,
the loss would be the strike price less the option price.
Read More : Risk and Return Characteristics of Options
