Options Strategies: Profits and Losses

Which strategy is best for you?

A quick recap. So far, we've introduced the two types of options -- calls and puts. We've highlighted that there are two sides to a transaction -- the buyer and seller. We've discussed how to get option quotes, what those quoted prices mean, and a little about how they change with various external factors. Now, let's try to tie these concepts together graphically, laying out the profit and losses from four basic option strategies. We'll use the following options on Dell (Nasdaq: DELL  ) , whose shares are trading at $22.50, to illustrate:

Option

Call

Put

Symbol

DLQHX

DLQTX

Strike Price

$22.50

$22.50

Expiry

Aug-07

Aug-07

Option Price

$1.85

$1.35

Basic strategy 1: The long (buy) call
Buying a call gives us the right to buy Dell for $22.50 until the third week of August 2007. We would pay $185 per contract (remember that options are sold in contracts of 100) for that right. How much can we make, and how much can we lose?

The loss part is easy. No matter how far Dell falls between today and expiry, our risk of loss is capped at the $185 per contract we're investing. If the market gets crushed, there's blood in the streets, dogs and cats are marrying each other, and Dell goes to $14 -- no problem. A bad situation, perhaps, for those who simply bought Dell shares outright and are now sitting on an $850 loss, but reasonably comfortable for our call buyer. On the other hand, there's (theoretically) no limit to how high Dell could go before expiry. And any rise in Dell's stock price will be matched, dollar for dollar, with a rise in the price of the call.

We can represent our profits and losses in both a tabular format and graphically with a simple two-axis plot. Profit equals the intrinsic value of the option less the cost to initially purchase the option. The horizontal axis shows the stock price at expiry, while the vertical axis shows the profit/loss potential. The shaded blue area above the horizontal axis is where the option is profitable, while the shaded blue area below the horizontal axis shows when the option buyer faces a loss.  

Long Call

Stock Price At Expiry

Profit/(Loss) At Expiry

$15

($1.85)

$20

($1.85)

$22.50

($1.85)

$24

($0.35)

$25

$0.65

$30

$5.65

Note that, though the option has a strike price of $22.50, the option buyer doesn't actually make a profit until the stock goes above $24.35 (the cost of the option plus the strike price). Also note that if the option expires when the stock price is between the break-even price and the strike price, the option buyer is still better off exercising, since some of the loss taken on the initial call buy can be recouped.

Basic strategy 2: The long (buy) put
We can similarly show a risk profile for any option position. Perhaps we're bearish on Dell's prospects and are seeking to profit by buying a put option. In such a case, our maximum loss is $135, while our maximum profit would occur if Dell went bankrupt before our option expiry (don't hold your breath).

Long Put

Stock Price At Expiry

Profit/(Loss) At Expiry

$15

$6.15

$20

$1.15

$21.50

($0.35)

$22.50

($1.35)

$25

($1.35)

$30

($1.35)

Basic strategy 3: The short (sell) call
What about the other side of the trade? Somebody is always selling the options that the counterparties are buying. The profit payouts of the option writers are the mirror opposites to those of the option buyers. So where a call buyer has a capped downside risk and unlimited upside, the call writer has a capped profit potential and an unlimited downside risk (hmm ... that doesn't sound like much fun).

Short Call

Stock Price At Expiry

Profit/(Loss) At Expiry

$15

$1.85

$20

$1.85

$22.50

$1.85

$24

$0.35

$25

($0.65)

$30

($5.65)

Those who go short calls are generally down on the stock's prospects, at least until expiration. In isolation, those who go short calls are playing with fire with that potential unlimited downside.

Basic strategy 4: short (sell) put
Finally, the short put mirrors the profit and loss profile of the long put and is generally employed by those who are bullish on the underlying stock. The maximum potential profit is equal to the money received upfront from the put sale, while the maximum loss occurs if the stock goes to zero. Someone who believes that Dell will do just fine in the near term may sell puts to gain extra income.

Short Put

Stock Price At Expiry

Profit/(Loss) At Expiry

$15

($6.15)

$20

($1.15)

$21.50

$0.35

$22.50

$1.35

$25

$1.35

$30

$1.35

  

Check out more of our options series here

If you are interested in receiving more information from The Motley Fool about investing in options, please click here.

Fool contributor Jim Gillies does not own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (145)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 15, 2011, at 4:40 PM, shelly998 wrote:

    I am a rookie to options and am trying to learn all that I can.... I have found these articles very helpful. Thank you! Keep up the good work!

  • Report this Comment On October 09, 2011, at 6:30 PM, xterra808 wrote:

    I disagree with the unlimited downside risk potential for sellers of calls. The downside risk is capped by the difference between the strike price and the price the stock was originally purchased at. If say in this example, the Dell stock was originally purchased at $25.00 and a $22.50 strike call option was sold (which I personally wouldn't do myself due to the potential loss), in the event of an excercise by the call purchaser the loss would be limited to $250, which would also be offset by the $185 gained on the sale of the stock. So only a total loss of $65.00 would result.

    Now if the Dell stock was purchased at say $21.00 per share, when the call option is excersized at $22.50, the call writer would gain an additional $1.50 per share in addition to the $1.85 gained when the call option was written. For a total income of $3.35 per share or $335. Which by the way would equate to a handsome return of almost 16% for the short period of the option holding.

  • Report this Comment On October 21, 2011, at 11:15 AM, brigittee wrote:

    GSK 10/22/2011 41C. Wrote one and was credited $160.30 net. Bought underlying stock some time ago at 39.30. With the stock value at 44.80, I need help to decide if to buy back the call or roll it to a 44C?

    Any feedback I can get is much appreciated. Am still a rookie.

    Thanks so much.

  • Report this Comment On December 07, 2011, at 4:31 PM, usc76a wrote:

    Let it go. No guarantee the stock will stay at current level or continue move upward. Take the money and if u like the stock you can always buy it back on a pull back or move on to another investment.

  • Report this Comment On December 07, 2011, at 4:33 PM, usc76a wrote:

    Also, u can sell a naked put against the proceeds from the sale and either be put the stock at a lower price, or pocket the premium.

  • Report this Comment On February 24, 2012, at 10:01 PM, gsrays wrote:

    Not sure if this is the correct place for this question. If not, please direct me to the correct board.

    I sold covered calls in Oct 2010 that became worthless at expiration in Feb 2011. !00% profit for me minus brokerage costs. Do I pay taxes in 2010, the year I got the money or 2011, the year the option expired worthless.

    Thank you very much.

    Jerry

  • Report this Comment On December 08, 2012, at 11:59 AM, bgros wrote:

    i lost the page for option advise i would like to be part of the option pram for $999.00

  • Report this Comment On February 06, 2014, at 10:59 PM, spadeknight wrote:

    ill have to read this stuff about five times or more to understand it. however if the fool would use video instruction it might make more sense to me. i want to learn this stuff but its like math class. ill keep trying to understand it. thanks for the article.

  • Report this Comment On April 05, 2014, at 9:38 AM, amhoov16 wrote:

    Nice article on options. Would like to see an article on SPX and VIX options.

  • Report this Comment On November 08, 2014, at 4:41 PM, phillsil wrote:

    hi everyone

    i have been operating with the idea that if the option, a call ,shows a gain of 50% i sell

    so far so good

    don't care if i have owned the option one day or a month

    your thoughts

    I am new at this

    Just makes sense not to leave money on the table wit so many unknowns

    this month

    made more than enough pay to pay for puts on my long positions for the year

    Phillip

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