Long Call
-
belief that stock will rise (bullish outlook)
-
risk limited to premium paid
-
unlimited maximum reward
Short Call
-
belief that stock will fall (bearish outlook)
-
maximum reward limited to premium received
-
risk potentially unlimited (as stock price rises)
-
can be combined with another position to limit the risk
Long Put
-
belief that stock will fall (bearish outlook)
-
risk limited to premium paid
-
unlimited maximum reward up to the strike price less the premium paid
Short Put
-
belief that stock will rise (bullish outlook)
-
risk unlimited down to the Strike Price less the premium received
-
maximum reward limited to the premium received
-
can be combined with another position to limit the risk
We already know that a call option is the right to buy an asset. Logically, this suggests that the call option risk profile direction will be similar to that of buying the
asset itself. So let's have a look at an example:
Stock Price
|
$56.00
|
Call Premium
|
$7.33
|
Exercise Price
|
$50.00
|
Time to Expiration
|
2 months
|
Remember that:
Buying gives you the Right
-
Buying a call option gives you the right, not the obligation to buy an underlying instrument (eg a share).
-
When you buy a call option you are not obligated to buy the underlying instrument - you simply have the right to do so at the Strike Price.
-
Your maximum risk, when you buy an option, is simply the price you paid for it.
-
Your maximum reward is uncapped.
For every call that you buy, there is someone else on the other side of the trade. The seller of an option is called an option writer. Logic and common sense
tell us that the option seller's risk profile must be different to that of the option buyer.
Stock Price
|
$56.00
|
Call Premium
|
$7.33
|
Exercise Price
|
$50.00
|
Time to Expiration
|
2 months
|
Remember that we already discussed the implications of selling an option - here's a reminder:
Selling (naked) imposes the Obligation
-
Selling a call obliges you to deliver the underlying asset to the option buyer.
-
Selling options naked (ie when you have not bought a position in the underlying instrument or an option to hedge against it) will give you an unlimited risk profile. The continuous
downward diagonal line is generally a bad sign because it means unlimited potential risk.
-
Combined with the fact that you are obliged to do something, this is not an ideal strategy for the inexperienced, however it can be combined with other positions to create a new strategy.
So, now you know what long and short calls look like, let's look at the risk profile of a put option.
We already know that a put option is the right to sell an asset. Logically, this suggests that the put option risk profile direction will be the opposite to that of calls or
buying the asset itself. So, again, let's have a look at an example:
Stock Price
|
$77.00
|
Put Premium
|
$5.58
|
Exercise Price
|
$80.00
|
Time to Expiration
|
4 months
|
Remember that:
Buying gives you the Right
-
Buying a put gives you the right, not the obligation to sell an underlying instrument (eg a share).
-
When you buy a put you are not obligated to sell the underlying instrument - you simply have the right to do so at the Strike Price.
-
Your maximum risk, when you buy an option, is simply the price you paid for it.
-
Your maximum reward is uncapped. With long puts your reward is uncapped to the downside, ie the strike price less the put premium. In this example
that is: $80.00 - $5.58 = $74.42.
For every put that you buy, there is someone else on the other side of the trade. The seller of a put option is will have a different risk profile to that of the put option buyer.
Stock Price
|
$77.00
|
Put Premium
|
$5.58
|
Exercise Price
|
$80.00
|
Time to Expiration
|
4 months
|
Remember that we already discussed the implications of selling an option - here's another reminder for puts:
Selling (naked) imposes the Obligation
-
Selling a put obliges you to buy the underlying asset to the option buyer. Remember, when you sell a put, you have sold the right to sell to the person who
bought that put.
-
Selling options naked (ie when you have not bought a position in the underlying instrument or an option to hedge against it) will give you an unlimited risk profile. The continuous
downward diagonal line is generally a bad sign because it means uncapped risk.
-
Combined with the fact that you are obliged to do something, this is not an ideal strategy for the inexperienced.
You have now learned what the essential risk profiles look like and what they mean to you in terms of maximum risk and reward.
Profile
|
Description
|
Max Risk
|
Max Reward
|
Breakeven
|
|
|
Buy Asset
|
purchase price
|
uncapped
|
purchase price
|
|
Sell Asset
|
uncapped
|
short sale price
|
short sale price
|
|
|
Buy Call
|
call premium
|
uncapped
|
strike price plus call premium paid
|
|
Sell Call
|
uncapped
|
call premium received
|
strike price plus call premium received
|
|
|
Buy Put
|
put premium
|
strike price less put premium paid
|
strike price less put premium paid
|
|
Sell Put
|
strike price less put premium received
|
put premium received
|
strike price less put premium received
|