How to Calculate Profit on Call Option

Generalising the P&L for a Call Option Buyer

Taking into consideration the intrinsic value of the 475 Call Option, let us construct a table to ascertain how much money I shall make from my purchase under different influences on Tata Motors’ spot value change. Considering that I paid Rs 12.50 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 evident that several significant points stand out:

If Tata Motors’ rate drops below a strike price of 475, the maximum loss appears to be approximately Rs 12.50

A call option buyer can incur a loss when the spot price is lower than the strike price, but this loss is limited to the premium paid

This call option looks increasingly profitable as Tata Motors rises above the strike price of 475

The call option will be profitable when the spot price surpasses the strike price. The more the spot price outperforms the strike, the greater the return

It’s reasonable to deduce that the call option buyer has a limited downside, but potentially limitless upside

This represents 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.

430

490

485

At 430:

= Max [0, (430 – 475)] – 12.50

= Max [0, (-45)] – 12.50

= 0 – 12.50

= -12.50

The answer is similar to generalisation 1, i.e. the potential loss is limited to the amount of the premium paid.

At 490:

= Max [0, (490 – 475)] – 12.50

= Max [0, (+15)] – 12.50

= 15 – 12.50

= +2.50

The response provided aligns with Generalisation 2, which states that a call option becomes profitable when the spot price surpasses the strike price.

At 485:

= Max [0, (485 – 475)] – 12.50

= Max [0, (+10)] – 12.50

= 10 – 12.50

= -2.50

This is a tricky scenario; our result contradicts the second generalisation. Although the spot price is higher than the strike price of 475, this trade still resulted in a loss. The loss is fewer than the maximum of Rs 12.50, standing at only Rs 2.50. To comprehend why this is occurring, 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 12.50 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 Tata Motors example, the ‘Break Even’ point is:

= 475 + 12.50

= 487.50

Let’s determine the P&L at the breakeven point:

= Max [0, (487.50 – 475)] – 12.50

= Max [0, (+12.50)] – 12.50

= +12.50 – 12.50

= 0

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 buyer of a call option will only experience a loss to the amount of the premium paid. They will continue to lose if the spot price remains beneath the strike price

If the spot rate surpasses the strike price, the purchaser of a call option can potentially achieve unlimited profit

To benefit from a call option, the buyer needs to ensure that the spot price moves above the strike price to make a profit. However, he will first need to recoup the premium he has paid out

The call option buyer begins to earn a return once they reach the breakeven threshold, which is higher than the strike price

The graph of Tata Motors’ Call Option trade provides an illuminating view of the mentioned factors

The chart demonstrates the points we discussed. We can see that…

In the above chart, you can observe the following:

The cap for losses is set at Rs 12.50, assuming the spot rate does not exceed 475

From 475 to 487.50, we can observe a decrease in the amount of losses. At this point, the losses will effectively be neutralised

At this point, it is clear that there is no financial gain or detriment

After the spot value surpasses 487.50, the call option starts to generate a positive return. The profitability of the option accelerates exponentially as the spot price deviates further from the strike price

As depicted by the graph, a call option buyer faces restricted risk whilst having the possibility of unlimited profit. Having analysed the perspective of the buyer, the subsequent chapter will delve into the viewpoint of the seller.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding profit and loss mechanics proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending call option payoff structures enables more informed investment decisions.

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