Call and put options are two fundamental tools in option trading, offering the right to buy or sell underlying assets at predetermined prices.
Yet, understanding their potential outcomes can be complex. However, that is where payoff diagrams come into the picture. These basic graphs show a visual representation of potential profits and losses that simplify the understanding of option market complexities.
You can also enroll in Upsurge.club’s option trading full courses in Hindi and English to get a comprehensive understanding of these concepts. In this article, we will provide an overview of what a call and put payoff diagram means.
What is a Call Option Payoff Diagram?
A Call Option Payoff Diagram is a graphical representation illustrating the potential profit or loss of a call option strategy at expiration, based on different underlying asset prices. It consists of the strike price on the x-axis and the profit or loss on the y-axis, typically plotted as a line graph.
A call option gives the right but not the obligation to buy the underlying security at a specific strike price. The intrinsic value or payoff upon expiration of this option depends on whether the underlying stock’s price is greater than or less than, as well as equal to its call option’s strike rate.
Here is an example:
In the graph, it is clear that the strike price of the option (₹47.00) acts as a dividing point for the payoff function into two separate segments. Below this price, the graph shows a constant and negative result, meaning the trade results in a loss. But above the strike price, the line slopes upwards.
This means that as the price of the underlying asset goes up, the profit from the call option also goes up. There’s a specific point (we call it the break-even point, which is ₹47.88 in our example) where the line crosses zero, indicating that the trade starts making a profit from that point onwards.
A call option payoff diagram can help you understand and analyze option strategies before trading. The diagram shows the profit potential, risk potential, and break-even point of a potential option play.
What is the Put Option Payoff Diagram?
A put option payoff diagram is a graphical representation of the potential profit or loss from a put option at expiration, along with the breakeven point of the transaction. The graph shows option buyer and seller profits and losses at different price levels.
Here is an example: We have taken a different market this time.
Let’s take a look at what happens when you use a long-put option strategy.
Imagine you’re a trader who bought a put option with a strike price of $25, paying $2 for each contract (which represents 100 shares, so $200 in total). The maximum you can lose is the $200 premium you paid. That happens if the stock price is $25 or higher.
As the stock price drops below $25, your potential profit starts to increase. You hit the break-even point when the stock price falls below $22 ($25 – $2 premium).
If you paid a slightly higher premium, say $2.20, then your break-even point would be $22.80.
A put option has intrinsic value when the price of the underlying asset is less than the strike price. The option will have time value until the market closes on its expiration date, after which it will either have intrinsic value or be worthless.
Also Read: Beginners’ Guide to Online Share Trading in India
The payoff diagram for a put option buyer and seller are mirror images of each other. This means that the maximum loss for the buyer is the maximum profit for the seller, and vice versa. The buyer has unlimited profit potential, while the seller has maximum loss potential. It will work the same for the Indian market.
Conclusion
Now that you understand the basics of call-and-put options and why payoff diagrams are important, you’re ready to learn even more about trading. If interested, you can check out the share market full course in Hindi on Upsurge.club These courses can teach you valuable strategies and tips to help you make smart decisions when trading.
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