Forward and futures contracts Video transcript Payoff diagrams are a way option payout function depicting what an option or set of options or options combined with other securities are worth at option expiration. What you do is you plot it based on the value of the underlying stock price. And I have two different plots here, one that you might see more in an academic setting or a textbook, and one that you might see more if you look up payoff diagrams on the internet, or people actually trading options.
But they're very similar. This one just worries about the actual value of the options at expiration. This worries about the profit and loss.
And here the same for short call position the inverse of long call. Call Option Payoff Diagram Buying a call option is the simplest of option trades. A call option gives you the right, but not obligation, to buy the underlying security at the given strike price. The key variables are: Strike price 45 in the example above Initial price at which you have bought the option 2.
So this will incorporate what you paid for the option, this will not. This just says what it is worth.
If it was a European option, it would be on expiration. So what is the value of this option at expiration? So this is value at expiration.
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So the option would be worthless. It would be worthless.
Payoff Diagrams for Options - Call Options - Put Options - Options Long - Options Short
They would just let it expire. No reason to actually exercise the option. And so you have a payoff diagram that looks something like this.
It kind of hockey sticks. Now, if you do it in the profit and loss model, all you have to do is incorporate what you actually paid for the option.
Long Put Option Position is Bearish While a call option gives you the right to buy the underlying security, a put option represents the right but not obligation to sell the underlying at the given strike price. When holding a put option, you want the underlying price go down, because the lower it gets relative to the strike price, the more valuable your put option becomes. A long put option position is therefore a bearish trade — makes money when underlying price goes down and loses when it goes up. Put Option Payoff Diagram You can see the payoff graph below.
You have lost the price of the option because you wouldn't exercise it. So there you are break even. So these are both legitimate payoff diagrams for a call option, for this call option right over here.
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They're just different ways of viewing it. This is the value of option payout function option.
This incorporates the actual cost of it.