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Creating a map when buying options

Lesson in Course: Derivatives and options (advanced, 9min)

I want to start taking the first steps in buying options. How do I make a plan?

Eureka!

What it's about: Making sense of pay-off diagrams when buying a put or call option.

Why it's important: Visually we can see when we make or lose money and how much is at stake.

Key takeaway: The maximum possible loss when buying a put or call option is the price paid.

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.

Khan Academy
https://www.youtube.com/watch?v=MZQxeQYQCUg

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. 

What is  Value diagram?

The value diagram for an option contract is a visual representation of the intrinsic value at maturity compared to the underlying stock price.

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. 

Value diagram for a call and put

We can see above that as the stock price increases, the call option becomes more valuable. When the stock price decreases, the put option becomes more valuable. An option is in-the-money (ITM) if the intrinsic value is positive, or the line of the value diagram is sloped. An option is out-of-the-money (OTM) if the intrinsic value is $0. At-the-money (ATM) options still have the intrinsic value of $0, but the slope is starting to form.

We'll use an example to help us understand the graphs. 

Verizon call option value diagram

Let's assume Verizon ($VZ) is trading at $50 a share. We ended up paying $10 in premiums for an at-the-money call option with the strike price of $50.

The minimum value of the graph is always $0.  Since the strike price is $50 in our example, the call option is only in the money if the underlying stock is above $50. As the option becomes in-the-money, the value of the options increases on a dollar-per-dollar basis. For example, when $VZ is at $51 per share, our option has an intrinsic value of $1 and at $52 per share, our option is worth $2...etc.

 Let's look at an example of the same put option.

Verizon put option value diagram
The put option is in light red

The put value diagram is in light red and is overlayed on top of the call value diagram. Since we are betting against the stock, our option is in-the-money as long as the price of $VZ is below the strike price of $50. The option increases in value on a dollar-per-dollar basis after the underlying stock price drops below $50 a share. For example, when the underlying is at $49 per share, our option is worth $1 and at $48 per share, our option is worth $2...etc.

The profit diagram is different than the value diagram since it includes the cost we paid for the price of our option.

What is Profit diagram?

The profit diagram for an option is a visual representation of the profit and loss at maturity relative to the underlying stock price.

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.

Profit diagram for a call and put

In both the call and put examples above, we start in the negative. The negative amount is the same as the price paid for the options. 

Let's step through the Verizon example again.

Verizon call option profit diagram

The call option example above shows that when the stock is at $50, we have a loss of $10. The call option is at-the-money and we would never exercise the option even though we paid $10. It isn't until the underlying stock is at $60 that we are at our break-even point (strike price + premium per share). And beyond $60, we are profitable on a dollar-per-dollar basis if we exercise.

 
Verizon put option profit diagram
The put option is in red

The profit diagram for a put option, like the call option, shows that we have a loss of $10 in premiums paid when our option is at-the-money. The break-even point is shown where the red line crosses the X-axis and is below our strike price and can be calculated as (strike price - price per share). We have to be in-the-money the same amount as the premiums we paid to break even. When $VZ is below $40, our graph turns positive and we are profitable on a dollar-per-dollar basis.

 

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.

 

Actionable ideas

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?

 

Glossary

What is  Value diagram?

The value diagram for an option contract is a visual representation of the intrinsic value at maturity compared to the underlying stock price.

What is Profit diagram?

The profit diagram for an option is a visual representation of the profit and loss at maturity relative to the underlying stock price.