- Criteria for Successful Investing
- Risk Profile Charts
- The Definition of an Option
- The Valuation of Options
- Intrinsic and Time Value for Calls
- Intrinsic and Time Value for Puts
- The Seven Factors that Influence an Option’s Premium
- Risk Profile Charts for Call Options
- Risk Profile Charts for Put Options
- Memory Tips for Long and Short Calls and Puts
- Basic Risk Profiles Summary
- Chapter 1 Major Learning Points
This chapter is from the book
This chapter is from the book
This chapter is from the book
Risk Profile Charts for Call Options
Now that you know what makes up the valuation of an option, let’s look at the risk profile of a call option.
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:
)
Chart 1.3 Long Call option risk profile.
Look back to Example 1.2 where you buy a call option:
|
Stock price |
$56.00 |
|
Call premium |
$7.33 |
|
Exercise price |
$50 |
|
Time till 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 (that is, 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 fixed (exercise or strike) price.
- Your risk, when you buy an option, is simply the price you paid for it.
- Your reward is potentially unlimited.
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 from that of the option buyer.
So, staying with calls, let’s see the option writer’s risk profile perspective:
)
Chart 1.4 Short Call option risk profile.
Still taking Example 1.2 of the following call option:
|
Stock price |
$56.00 |
|
Call premium |
$7.33 |
|
Exercise price |
$50 |
|
Time till 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 option obliges you to deliver the underlying asset to the option buyer.
- Selling options naked (for example, 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 line is generally not a good sign because it means unlimited potential risk.
- Combined with the fact that you are obliged to do something, this is generally not a preferable position in which to put yourself.