This article was written by Chris Young and first published on Epsilon Options (now part of SteadyOptions).
Below, we construct this payoff diagram for both long and short call options considering the movement of the call option price at expiration relative to the strike price.
Long call option payoff
Consider the simplest example. For example, a long call option with a strike price of 100 that expires in 3 months. Suppose also that the current stock price is 90. I hope the stock will rise above 100 at maturity so that the call can be exercised or sold due to its value.
To purchase a call, you must pay an option premium. All things being equal (especially the implied volatility), it depends on the time to maturity (three months in this case). Let this premium be 10.
After expiration, one of the following scenarios will occur:
The stock price is below a strike price of 100 (that is, the option is out of the money).
In this case, the trade will not work as planned and the call option will expire worthless. So the profit/loss will be:
-
Premium paid: -$10
-
Profit from call option: $0
-
Trade Loss: -10
Stock price between 100 and 110
The call option is in the money, which is good news. Since there is no intrinsic value (the option’s value from the time remaining in the option), its value is its extrinsic value (the stock price minus the strike price).
However, this amount is small (between 0 and 10) and increases as the stock price approaches 110.
However, it is still a loss as it is not enough to recover the 10 you paid for the call option premium.
Our Profit/Loss – For example, assume a stock price of $105 is:
-
Premium paid: -$10
-
Profit from call option: $5
-
Trade Loss: -5
stock price is 110
This is the break-even point of the option.
At 110, the option will be worth $10 at expiration and you will get back the $10 option premium you paid.
No profit or loss. Traders will break even:
-
Premium paid: -$10
-
Profit from call option: $10
-
Trade Profit/Loss: $0
Stock price over 110
This is where traders start making profits.
Expired options are now worth more than $10, more than getting back the $10 option you paid.
For example, if the stock price is 115:
-
Premium paid: -$10
-
Profit from call option: $15
-
Trade Profit/Loss: $5
This benefit increases the further the stock price is from the 110 strike price. It’s potentially infinite (because it’s unlikely, but the potential stock price is infinite).
Putting all this together for all possible stock prices gives us the following payoff graph.
![Call option payoff diagram](https://epsilonoptions.com/wp-content/uploads/image-15.png)
The horizontal x-axis is the stock price at maturity.
Payoffs for short call options
What if a trader sells a call option instead of buying it, hoping that the stock price never goes above 100 and keeps a premium of 10 at no cost?
Let’s look at the scenario again.
The stock price is below a strike price of 100 (that is, the option is out of the money).
In this case, the trade works as planned and the call option expires with no value. So the profit/loss will be:
-
Premium received: $10
-
Loss on call option: $0
-
Trade Profit: $10
Stock price between 100 and 110
The call option is in the money, which is bad news. Since there is no intrinsic value (the option’s value from the time remaining in the option), its value is its extrinsic value (the stock price minus the strike price).
However, this amount is small (between 0 and 10) and increases as the stock price approaches 110.
However, it is still profitable as it is not enough to wipe out all the 10 call option premiums received.
Our Profit/Loss – For example, assume a stock price of $105 is:
-
Premium received: $10
-
Loss on call option: -$5
-
Trading Profit: $5
stock price is 110
This is the break-even point of the option.
At 110, the option is worth $10 at expiration and all $10 option premiums received are removed.
No profit or loss. Traders will break even:
-
Premium received: $10
-
Loss on call option: -$10
-
Trade Profit/Loss: 0
Stock price over 110
This is where traders start making (potentially infinite) losses.
Expired options are now worth more than $10, more than getting back the $10 option you paid.
For example, if the stock price is 115:
-
Premium received: $10
-
Loss on call option: -$15
-
Trade loss: $5
Calculating the break-even point
As we have seen, the break-even point for a long or short call option position is the expiry price at which neither profit nor loss is incurred.
It can be calculated using the following formula:
Conclusion
The payoff of a call option is a function of the price of the underlying stock at expiration.
For long/short positions, profit is made if this price is higher/lower than the break-even point, which is calculated as the sum of the strike price and the option premium paid/received.