How to Calculate Profit in Options Trading? – Basics of Options Profitability

How to Calculate Profit in Options Trading? – Basics of Options Profitability

Understanding how to calculate profit in Options trading: Options are considered one of the most complex products that traders come across in the world of the stock market. Due to this, beginners, as well as experienced traders, tend to avoid this segment also due to the high risk involved in it.

But one should take into account that the high risk associated with options also carries a high reward in the form of high returns. So, with proper judgment and implementing the right strategies, options trading can prove to be an excellent way to increase your net worth.

In this article, we are going to look at ways in which one can become profitable in options trading. However, before we discuss how to calculate profit in options trading, let us also brush up on the basics of options trading first.

What are the Options?

Before jumping into the conceptual analysis of various methods to calculate profit in options trading, let us understand what options mean. In order to understand options in a simple manner, you’ll first need to understand what a futures contract is.

A futures contract is an agreement made between two parties through an organized exchange, wherein one party agrees to buy and the other party agrees to sell a commodity or a financial asset, at a pre-decided price on a future date. 

So on the date of expiration of the futures contract, the buyer has to buy and the seller has to sell the commodity or financial asset irrespective of them being in profit or loss. This is where options come into play.

An options contract is just like a futures contract, but here, the buyer of the option contract has a right to execute the order (i.e. to buy or sell the commodity) on the expiry of the contract but not an obligation to do so.

The term option refers to a financial instrument that is based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell depending on the type of contract they hold for the underlying asset.

So during the expiration of the contract, the buyer of the contract has a choice of not executing the contract if he incurs a loss in doing so. For having the privilege of choice of execution, the buyer has to pay a price to the seller of the contract called “option premium”.

Quick Read: 5 Best Options Trading Courses For Beginners!

Who All are Involved in an Options Trading Contract?

Here are the two parties that are involved in an Option Contract:

Buyer of option: He is the one who has a right but not an obligation to execute the contract. For having this right, the buyer has to pay a price to the seller (forgoing his right). This price is also called Fees, Option Premium.

For an option buyer, the loss incurred is limited to the premium paid by him, because he has a choice of not executing his trade upon expiry.

Seller/ Writer of option: He is the one who writes the contract and gives his right to the buyer of the Option. He receives the ‘option premium’ and is hereby obligated to sell/buy the underlying asset if the buyer of the option chooses to exercise his right.

For an option seller, the profit incurred by him is limited to the premium received by him, and the loss incurred can be unlimited when the buyer executes the contract.

Basic Terminologies Used in Options

Here are the key terminologies that you should know in order to do the calculations of Profit in Options Trading:

  • Spot Price: It refers to the current price of a security at which it can be bought/sold at a particular place and time.
  • Strike Price: It is a set price at which an option contract can be bought/sold if exercised.
  • Option Premium: It is the price that the option buyer pays to the option seller.
  • Break-even point: It is the point at which total cost and total revenues are equal.
  • Underlying Asset: It is the security upon which a derivative contract is based. Security can be an asset or commodity like crude oil, gold, or stock.

Moneyness of an Option

Moneyness of options is a term to describe whether a contract is either “in the money”, “out of the money”, or “at the money”.

  • In the money option (ITM): This option would give the holder a positive cash flow if it is exercised immediately.
  • At the money option: (ATM)This option would give the holder a zero cash flow if it is exercised immediately.
  • Out of the money option (OTM): This option would give the holder a negative cash flow if it is exercised immediately.

Calculation of Profit in Options Trading

Now that we have understood what an Option is, let us move on to how an individual can earn profit in options trading.

1. Profit Calculation in Call Option

In a call option, the buyer of the option contract will get the right to buy the underlying asset but not the obligation to do so. For this right, the buyer pays a ‘premium’ to the seller.

With the help of an example, let’s now determine the profit-making scenario of a call option buyer and seller.

1.1 Buyer of Call Option

Example 1; Buyer buys a call options contract with a strike price of Rs 1,500 and pays a premium of Rs 200. We will now take a look at the profit or loss situation at different spot prices during expiry for the buyer.

  • The spot price reaches Rs 2,000: Here the market has moved in the favour of the buyer of the options contract. The profit he will make in this situation is calculated using the call option profit formula –

Profit/ Loss=Spot Price – Strike Price – Premium Paid

Profit/ Loss = 2000-1500-200 = 300

  • The spot price stops at Rs 1,500: Since the spot price is at the same level as the strike price, the buyer will incur a loss limited to the premium paid, irrespective of him executing the order or not.

Loss= 1500-1500-200= -200

  • The spot price closes down at 1,200: Here the market has moved against the favor of the buyer of the options contract and he will not execute the contract. The loss will be limited to the premium paid by him. 

Loss= -200

Profit in Options Trading | Buyer of Call Option

It should be noted that, as the strike price is Rs 1,500 and the premium paid is Rs 200, the buyer of the option contract will start making profits only when the spot price rises above Rs 1,700(break-even point). 

1.2 Seller of Call Option

Example 2: Seller writes/sells an options contract with a strike price of Rs 1,500 and receives a premium of Rs. 200. We will now take a look at the profit or loss situation at different spot prices during expiry for the seller. Let’s understand how to calculate profit on options:

  • The spot price reaches Rs 1,200: Since the market has moved against the buyer of the contract, he will choose not to execute the contract and the seller/writer of the contract gets the benefit of the premium received.

Profit= 200

  • The spot price stops at Rs 1,500: Since the spot price is at the same level as the strike price, the seller will get profits limited to the premium paid, irrespective of whether the buyer executing the order or not.

Profit=200-1500-1500= 200

  • The spot price reaches Rs 2,000: Here the market has moved in the favour of the buyer of the options contract. So the loss the seller will make in this situation is:

Received= 200

Paid to the buyer= 2000-1500= 500

Net loss for the seller= 200-500= -300

Calculate Profit in Options Trading | Seller of Call Option

The profits for the seller/writer of the call option are limited to the premium received by him and his profits start reducing once the spot price exceeds the strike price. The seller/writer will start making losses when the spot price exceeds Rs 1,700.

2. Profit Calculation in Put Option

In a put option, the buyer of the option contract will get the right to sell the underlying asset but not the obligation to do so. For this right, the buyer pays a ‘premium’ to the seller.

With the help of an example, let’s now determine the profit-making scenario of a call option buyer and seller.

2.1 Buyer of Put Option

Example 3; Buyer buys a put option contract with a strike price of Rs 1,500 and pays a premium of Rs 200. We will now take a look at the profit or loss situation at different spot prices during expiry for the buyer.

  • The spot price reaches Rs 1,000: Here the market has moved in the favour of the buyer of the options contract. The profit he will make in this situation is:

Profit/ Loss=Strike Price – Spot Price – Premium Paid

Profit = 1500-1000-200 = 300

  • The spot price stops at Rs 1,500: Since the spot price is at the same level as the strike price, the buyer will incur a loss limited to the premium paid, irrespective of him executing the order or not.

Loss= 1500-1500-200= -200

  • The spot price goes to Rs 1,800: Here the market has moved against the favor of the buyer of the options contract and he will choose not to execute the order. The loss to the buyer is limited to the premium paid by him

Loss= -200

Buyer of Put Option

It should be noted that, as the strike price is Rs 1,500 and the premium paid is Rs 200, the buyer of the option contract will start making profits only when the spot price drops below Rs 1,300 (break-even point).

2.2 Seller of Put Option

Example 4: Seller writes/sells a put options contract with a strike price of Rs 1,500 and receives a premium of Rs. 200. We will now take a look at the profit or loss situation at different spot prices during expiry for the seller.

  • The spot price reaches Rs 1,800: Since the market has moved against the buyer of the contract, he will choose not to execute the contract and the seller/writer of the contract gets the benefit of the premium received.

Profit= 200

  • The spot price stops at Rs 1,500: Since the spot price is at the same level as the strike price, the seller will get profits limited to the premium paid, irrespective of whether the buyer executing the order or not.

Profit=200-1500-1500= 200

  • The spot price reaches Rs 1,000: Here the market has moved in the favour of the buyer of the options contract. So the loss the seller will make in this situation is:

Received= 200

Paid to the buyer= 1500-1000= 500

Net loss for the seller= 200-500= -300

Seller of Put Option

The profits for the seller/writer of the put option are limited to the premium received by him and his profits start reducing once the spot price drops below the strike price. The seller/writer will start making losses when the spot price decreases below Rs 1,300.

Also Read: What is Put Call Ratio in Options Trading? How to Interpret it?

What Is Option Formula?

Following are the option formula used to calculate the intrinsic value for call options and put options:

Call option

Intrinsic value = Underlying Stock’s Current Price – Call Strike Price

Time Value = Call Premium – Intrinsic Value

Put option

Intrinsic value = Call Strike Price – Underlying Stock’s Current Price

Time Value = Put Premium – Intrinsic Value

In Closing

People frequently think that trading options are difficult. But if you properly understand the derivatives sector, you can highly increase your chances of increasing your wealth.  

You can increase you improve your expertise in options through various educational sources and by practically applying the knowledge you’ve gained in options.

So here we come to the end of this article on calculate profit in options trading, hope you are walking away with more knowledge about options than you came in with, Do let us know if you have queries regarding profits in options trading in the comment section below. Also, If you want to learn more about investing and trading, subscribe to our courses on FinGrad.

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