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3. Four basic profit and loss (P&L) calculations for option trading
A stock option is a financial contract based on individual stocks that is traded on an exchange and settled by a clearing house. The contracts are divided into call options and put options. In addition, options can be divided into American options and European options according to the exercise method. The vast majority of US stocks and ETF options are American options, while index options are generally European options.
The buyer of an American call option has the right to buy the underlying stock at the strike price on or before the expiry date of the contract, and the seller of the call option is obliged to sell the underlying stock at the strike price if the option is exercised.
The buyer of an American put option has the right to sell the underlying stock at the strike price on or before the expiry date of the contract, and the seller of the put option is obliged to buy the underlying stock at the strike price if the option is exercised.
The definition of the European option is similar to that of the American option, except that the option can only be exercised on the expiry date of the contract.
Option premium is the cost of an option or the price of an option transaction. The price of stock options traded on an exchange is displayed on a per-contract-basis. For example, if an option has a market price of $2, then the option buyer would need to pay premium * option multiplier = 2 * 100 = 200 for the option; on the other hand, the option seller receives the premium.
The breakeven point is defined as the stock price at expiration that makes the purchase or the sale of an option result in a P&L of zero.
Assuming the option multiplier is same as the share size of contract, the potential profit of buying a call option is theoretically unlimited since there's no limit to how high a stock could go. The maximum loss is the option premium * number of shares. Here the breakeven point is when the stock price equals the sum of the strike price and the option premium.
Suppose a trader buys a call option at the market price of $10, and the strike price of the option is $90. The breakeven point would be 10 + 90 = $100. On the expiration date:
1) If the price of the underlying stock is less than $100, the maximum loss is the option premium * number of shares. P&L = - option premium * number of shares = - 10 * 100 = -$1000;
2) If the price of the underlying stock is more than $100 e.g. $105, the maximum profit = (stock price - strike price - option premium) * number of shares = (105 - 90 - 10)*100 = $500
Assuming the option multiplier is same as the share size of contract, the maximum theoretical profit is the (strike price - the option premium) * number of shares, and the maximum loss is the option premium * the number of shares. The profit The breakeven point would be equal to the strike price minus the option premium.
Assuming the option multiplier is the same as the share size of contract, the maximum profit is the option premium received * the number of shares, but the potential loss of a short call could be unlimited.
Suppose a trader short sold a call option at the market price of $10, and the strike price of the option is $90. The breakeven point would be 10 + 90 = $100. On the expiration date:
1) The price of the underlying stock is $105. P&L = (option premium - stock price + strike price) * number of shares = (10 - 105 + 90) * 100 = -$500;
2) The price of the underlying stock is $95. P&L = (option premium - stock price + strike price) * number of shares = (10 - 95 + 90) * 100 = $500
Assuming the option multiplier is the same as the share size of contract, the maximum profit is the option premium received * the number of shares, but the theoretical maximum loss of a short put is the (strike price - option premium）* number of shares.
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Options trading entails significant risk and is not appropriate for all customers. It is important that investors read Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Supporting documentation for any claims, if applicable, will be furnished upon request.