Derivatives and options
I want to start taking the first steps in buying options. How do I make a plan?
Before we put any of our money at risk, we should understand all our possible outcomes. When will we make money? Or what situations will result in us losing money?
For options, we can create a visual map to help us answer these questions. This visual map is called a payoff diagram. A payoff diagram is a graphical representation of when the options are in-the-money, at-the-money, and out-of-the-money compared to the price of the underlying stock. Visually seeing the possible gains and losses of an option position will help us avoid situations where we are caught unprepared. Let's start by watching a quick 3-minute video starting with buying a basic call option.
Understanding payoff diagrams
Pay-off diagrams come in two flavors. A value diagram will tell us the moneyness of our options, or if they are in-the-money, at-the-money or out-of-the-money. While that could be helpful, a profit diagram will show us when we actually make money. Let's jump into understanding the difference between the two.
Call option value diagrams and put option value diagrams look inverted since a put is betting on a drop in stock price and a call is betting on a rise in stock price.
We'll use an example to help us understand the graphs.
Let's look at an example of the same put option.
The profit diagram is different than the value diagram since it includes the cost we paid for the price of our option.
By factoring in our cost to make the investment, we need the option to be further in-the-money for it to make sense for us as an investor.
Let's step through the Verizon example again.
Understanding what's at risk
When we are buying an option, the maximum loss for our option is always going to be our price paid. We can go as far left or right on the profit diagrams above, and the most we'll lose is -$10.
A call option gives us the right but not the obligation to buy the underlying stock at the strike. So even if VZ's price dropped all the way to $0, we can choose to walk away and forgo exercise. Likewise, we can choose to not exercise our put option and sell our stock at the strike price if the market gives us a better price. Understanding this will help us avoid unfortunate situations. We shouldn't buy options contracts if we can't afford to lose the premiums paid.
A helpful trick for us to identify a call option diagram right away is to imitate a phone with our fingers.
While value diagrams are helpful for us to get a grasp of when the option is in-the-money, profit diagrams are preferred for us to truly understand when we make money and how much we have at risk. Being comfortable reading profit diagrams will be essential for the complex options strategies that use multiple calls and puts such as a collar, iron condor, and different types of spreads.
For each of these profit diagrams, it's important to identify the maximum loss, break-even point, and when the option pays out on a dollar-per-dollar basis. Do we feel confident doing that today?