17.11 Pay-offs of options
The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. So go through the pay off of different basic payoffs carefully. Because it would form the basis for all your different option strategies.
The Option Buyer
1. Long call
If Mahesh believes the share of a company say Reliance is on the rise, he can purchase a call option without buying the share. Now lets assume that he bought a call option(strike price is Rs. 500 and premium is Rs. 50 ). The break even point for this trade is Rs.550. If at expiry date, the underlying share is trading at a point between Rs.500 and Rs. 550, he will be able to recover portion of the premium by exercising the option. If the share is above Rs.550 at this time, there will be a linear relationship between the share price and the profit. If the share price has moved up to Rs. 600 by the option expiry date, the profit on the option will be Rs. 50 (the difference between the exercise price, which is 500, and the current share price (Rs.600) , less the option premium, which is Rs. 50)