Options Payoffs and Profits & Losses (Calculations for CFA® and FRM® Exams)

AnalystPrep's Concept Capsules for CFA® and FRM® Exams
This series of video lessons is intended to review the main calculations required in your CFA and FRM exams.

*AnalystPrep is an Official GARP-Approved Exam Preparation Provider*

Options
The buyer of an option has the right but not the obligation to exercise the option. The maximum loss to the buyer is equal to the premium paid for the option. The potential gains are theoretically infinite. To the seller (writer), however, the maximum gain is limited to the premium received after writing the option. The potential loss is unlimited.

In an options contract, two parties transact simultaneously. The buyer of a call or a put option is the long position in the contract while the seller of the option, also known as the writer of the option, is the short position.

Long vs. Short
Here is it important to differentiate between the long and the short party in a contract. The buyer is always said to be long the option. This is quite easy to see for a call option.

However, for a put option, the long position in a put is betting that the underlying price will drop. As such, the long position in a put option is synonymous to being short the underlying.

Expiration
Exchange-traded stock options can either be American or European style. While European options can only be exercised at expiry, American options can be exercised at any point during the life of the option. The actual date of expiry is specified by the exchange.

Strike Prices
Тhe value of the stock directly controls the strike price. At the expiration date, the difference between the stock’s market price and the option’s strike price determines the payoff.

Moneyness
For Call Options:
▪ If the stock price exceeds the exercise price, the option is in-the-money (ITM).
▪ If the stock price is less than the exercise price, the option is out-of-the-money (OTM).
▪ If the current market price is equal to the strike price, the option is at-the-money (ATM).

For Put Options: Just the opposite
▪ If the stock price is less than exercise price, the option is in-the-money (ITM).
▪ If the stock price exceeds the exercise price, the option is out-of-the-money (OTM).
▪ If the current market price is equal to the strike price, the option is at-the-money (ATM).

Intrinsic Value and Time Value
The intrinsic value of an option is the difference between the prevailing market price of the underlying and the strike price.
▪ Intrinsic value of a call option = max(0, St − X)
▪ Intrinsic value of a put option = max(0, X − St)

[rozhinamouzadeh]

I cannot imagine how you have explained the subject in that amazing way... Thanks a million.

[rajaneeshkataru]

what an easy explanation even a beginner should be able to grasp without confusion !!!

[sonicytb]

cant thank you enought!!!! you made this topic super easy to understand in a structured way!!!

[lehlogonolomonini]

Clear explanation ever. Thank you so much

[sanoh_]

Thank you for this clear and concise explanation, it has helped me a lot

[nrahman]

Thank you so much, you have cleared my confusions so well !!

[ashutoshdash]

I really like this educator's videos. Is there a playlist of his lectures? Or his course on Analystprep portal??? I enjoy watching him more than the other educators.

[turbolaserwhack]

So clear and logical! All info fall into place with this structure! A Really great educator You are! (Other similar videos always left me confused, this one talks in a system!) One Question remains: What about the leverage? Usually an option contract controls 100 shares. Does it make the profitability much closer to the strike price? The break even happens with a 100x multiplier so the premium is absorbed within a few points from the strike price? All these examples are talking about one contract with one share?

[moumitaghosh]

thank you so much it is so helpful for exams

[noona]

Somebody please help me with this activity below;

An investor is speculating on Company ZZ shares. The shares are currently trading at $140 per share. The investor believes that Company ZZ’s shares will experience a bearish run, and she wants to use call options to take advantage of this. She finds that a call option on Company ZZ’s shares, with an exercise price of $120, is selling at a premium of $400. She decides to buy the call option and simultaneously writes another call option on Company ZZ’s shares, with an exercise price of $105, at a premium of $600. One call option is made up of 100 shares.

a) what is the net cost(gain) of the position
b) what is the maximum loss
c) what is the maximum gain
d) what is the break even
e) what can the investor do to retain the same profile of the option strategy in the scenario but using put options instead?