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Option Strategies
To manage the risk of an options transaction, it is important to be informed about the potential profits and losses that can be expected. Investors interested in options can use payoff diagrams to get a better understanding of the potential gains and losses that entering into contracts hold. A unique part of options is that they are used in combinations and also used with other instruments to give a synthesized risk reward structure. Some of the basic strategies used are explained in the following article. For the purpose of simplicity, we assume the options are European options and the commission, transaction costs and tax considerations have been omitted. However, these factors affect a strategies potential outcome.
Buying calls
The point at which a buyer recovers the premium paid for an option is called the breakeven point. Assume an option buyer purchases a call option with a strike price of $29 at a premium of $1. The following payoff diagram shows that the maximum loss that a call option holder can incur is $1 (i.e., the premium amount). The breakeven point in this strategy is $30, the strike price + Premium paid, as the buyer will not exercise the option unless the market price is $30 and above. However, the profit potential is unlimited, because there is no telling how high a stock can go.
Selling calls
Considering the above call option with the strike price of $29 and at a premium of $1, the payoff diagram would be different for the writer of this call who has an uncovered position. The maximum profit that can be earned by the writer is the premium amount. However, the loss can be unlimited.
Buying and Selling Calls
An investor can combine various options to customize their risk/reward profile. One simple strategy would be to purchase a put and a call option with the same strike price and premium. Assuming the buyer purchases a call and a put with the strike prices of $29 and a premium of $1. If the market price is less than $29 at the expiration date, the call option will be worthless and the put option will be valuable. In this case, the buyer will purchase the shares from the market (for less than $29) and sell them at $29 by exercising the put option. Similarly, if the market price at the expiration day is above $29, the buyer will simply exercise the call option and sell the shares at market price.
The maximum loss that the buyer of this strategy can incur is the total premium paid to purchase both the put and call option (i.e. $2 per share). However, the profit potential is unlimited no matter what direction the stock prices move.
