Generalising the P&L for a call option buyer
Taking into consideration the intrinsic value of the 2050 Call Option, let us construct a table to ascertain how much money I will make from my purchase under different influences on Mahindra’s spot value change. Considering that I paid Rs 6.35/– for this option, let us calculate potential profits and losses. No matter what happens in the spot market, this expense remains constant.
I want to remind you that the negative sign preceding the premium paid signifies a cash outflow from my trading account
From this table, it is clear that two significant points stand out.
This is a rule of thumb to calculate the potential profit or loss when dealing in Call options based on the current spot price.
P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid
Considering the formula introduced above, let us work out the P&L for several potential expiry spot levels.
= Max [0, (2025 – 3000)] – 6.35
= Max [0, (-975)] – 6.35
= 0 – 6.35
= – 6.35
The answer is similar to generalisation 1, i.e. the potential loss is limited to the amount of the premium paid.
= Max [0, (3080 – 3000)] – 6.35
= Max [0, (+80)] – 6.35
= 80 – 6.35
The response provided aligns with Generalization 2, which states that a call option becomes profitable when the spot price surpasses the strike price.
= Max [0, (3055 – 3000)] – 6.35
= Max [0, (+55)] – 6.35
= 55 – 6.35
This is a tricky scenario; our result contradicts the second generalisation. Although the spot price is higher than the strike price of 3000, this trade still resulted in a loss. The loss is fewer than the maximum of Rs.6.35/-, standing at only Rs.1.35/-. To comprehend why this is taking place, we should take a thorough look at the P&L behaviour near that spot price value.
The table above shows that the buyer initially incurs a maximum loss of up to Rs. 6.35 until the spot price equals the strike price. Beyond this juncture, losses start to reduce and continue to do so until it reaches a state where neither gain nor loss is incurred – the break-even point.
Here’s the formula to identify the breakeven point:
B.E = Strike Price + Premium Paid
For the Mahindra example, the ‘Break Even’ point is –
= 3000 + 6.35
Let’s determine the P&L at the breakeven point
= Max [0, (3006.35 – 3000)] – 6.35
= Max [0, (+6.35)] – 6.35
= +6.35 – 6.35
We can see that, at the break-even point, there are no profits or losses. Therefore, for the call option to be lucrative, it must move beyond the strike price and surpass the break-even point.
– Call option buyer’s payoff
We have already examined some pivotal characteristics of a call option buyer’s return. To reiterate,
The chart demonstrates the points we discussed. We can see that…
In the above chart, you can observe the following:
As depicted by the graph, a call option buyer faces restricted risk while having the possibility of unlimited profit. Having analysed the perspective of the buyer, the subsequent chapter will delve into the viewpoint of the seller.