An options contract gives the buyer the right to buy or sell the underlying asset at the strike price, but not both. The right given is dependent on the type of option in the contract.
Call Option: a call option gives the buyer the right to buy the underlying asset before or on a predetermined date in the future.
Put Option: a put option gives the buyer the right to sell the underlying asset before or on a predetermined date in the future.
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You have bought:
If the price rises to $7 on 31st December, then you will exercise your call option and purchase the share in Apple at the strike price of $5 each. This will cost you $500 for the 100 shares stated in the contract. If you sell the shares immediately at the market price of $7, you will earn $700 for the 100 shares. Your payoff from this options contract will be how much you earned at the end, which is $700 - $500 = $200.
Don’t forget that you had paid a premium of $80 for the options contract on 1st December as well! As such, your total profit for the options contract will be $700 - $500 - $80 = $120. You will have made $120 on your initial outlay of $80, or a profit of 150%. Compare this with the gain in the underlying share over the same period of just 56%. This is the power of leverage!
Your payoff is positive in this case because the market price of the Apple shares has risen. When the option is in a money-making position, we call it In-The-Money, or ITM for short. Let us look at when the option is in a losing position, or Out-Of-The-Money (OTM).
Same as before, you have bought:
If the price fell to $2 on 31st December, then you will not exercise your call option because you may buy the share at $2 from the market instead of the strike price of $5 from the option seller. Remember that you are under no obligation to exercise your call option. It is an “option” after all! Thus, your payoff will be $0 since the option will simply expire.
Alas, you had paid a premium of $80 on 1st December, so your total profit will be -$80, and you would have made a loss. Had you just bought the shares instead, you would have lost 56% over the same period, but instead, you have lost 100% of your initial outlay. This is also the power of leverage!
Once again, using the same factors as above:
However, this time, the market price of Apple shares has fallen to $0.50 on 31st December. Once more, you will not exercise your option, so your payoff is $0 as well. Your profit will be -$80, i.e. a 100% loss as before, in Example 2, even though this time the share price of Apple dropped by 89%!
The examples above show that the main benefit of options is that there is a payoff when the option is ITM, yet there is no negative payoff when the option is OTM. It will always be 0. Hence, no matter how Out-Of-The-Money your option is, your minimum payoff is always $0, and your maximum loss is always the premium you paid upfront. However, there is NO LIMIT to the amount of payoff that you could potentially have, based on the appreciation of the underlying asset.
Following Example 2, say the market price has now fallen to $2 on 31st December. Recall that a put option gives you the right to sell the asset at the strike price of $5 per share. So, at this point, you can buy 100 Apple shares from the market for $200 and exercise your put option to sell them at $500 to the option seller. This gives you a payoff of $500 - $200 = $300 and hence a profit of $500 - $200 - $80 = $220. As you can see, unlike an OTM call option, the put option you bought will be ITM.
TL;DR
In essence, if you expect the underlying asset price to rise, you should buy a call option; if you expect the underlying asset price to fall, you should buy a put option.
Let’s take a look at the relationship between your expected payoff & profit of owning an option and the future share price. We’ll use the example above, where the strike price of the option is $5 and the premium paid was $0.80 per share ($80 total for an option contract of 100 options).
THE DIFFERENCE BETWEEN CALL VS PUT OPTIONS. COMPLETED. ✅
Sources:
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