The profit diagram for an option is a visual representation of the profit and loss at maturity relative to the underlying stock price. The break-even point is where Profit = $0.
An options contract represents an exchange of value between two different investors. Within this contract, for every single dollar in value received by one investor, the other investor is losing the same amount.
Understanding this inverse relationship helps us to be able to construct payoff diagrams for selling options. To create payoff diagrams for selling options, we would simply just invert the purchase diagrams vertically.
Delta is a very versatile tool for us to get a peek at what's behind the scene for options. It provides an indication of the price sensitivity of our options to changes in the underlying stock price, and can also be used as an estimate for the chance of success.
The premiums, or prices, for option contracts can vary significantly for different underlying stocks as well as for the same stock.
The price for an option depends on:
- Moneyness; whether it's in-the-money, at-the-money, or out-of-the-money
- The price of the underlying stock
- The implied volatility, much like the need for insurance