I just finished reading the section on risk management. Now derivatives is probably my weakest area, so here’s a pedestrian question for you to peruse. From what I gather, the maximum gain to the buyer of a put is the strike price minus the put premium. This seems to also be true for the breakeven point (i.e. X - premium). Does that mean that the buyer of a put can never make $$ beyond the breakeven point? thanks.
lola, you’re correct regarding the maximum payoff, but breakeven will occur when the underlying stock price drops enough that the option’s intrinsic value equals the premium you paid. So maximum payoff to the long = put option exercise price - put option premium breakeven point to the long = price of underlying stock - put option premium Let’s work through a quick example. I pay a $5 premium to take the long position in a put option on a stock that’s currently trading at $100. My maximum payoff is $100 - $5 - $0 = $95 My breakeven point occurs when the stock price drops to $100 - $5 = $95 (because now the intrinsic value of my put option, $5, covers the option premium I paid). So both values are $95, but they represent different things. I hope that helps
…in an ATM put option…
Thanks, that helps a ton. hiredguns1, your illustrative explanation is great. Let me make sure I get this. So by way of another example: say a stock currently trades at $100, the strike on a put option is $110 (in the money), and the option premium is $5. so then, max payoff to long is $105? (X - premium) breakeven will happen when the instrinsic value = the option premium (i.e. $5), in that case the stock has to be trading at $105 for breakeven to occur? Does that look right? Even though max payoff and breakeven represent different things, does the price of the underlying stock at breakeven always equal the max payoff?
If you know of any put options with strike $110 on an underlier at $100 and the option is selling for $5, I would like some please.
Joey, I’m not that interested in the practical slant here. I just want to know if my reasoning is correct.
No - nothing makes sense if the option is priced less than its intrinsic value. The option must be worth at least $10.
lola, your calculations are correct. Joey’s speaking to the reasonableness of the numbers themselves. Specifically, that you’d have to pay over $5 for something already worth $10 (i.e. option premium >= intrinsic value). They’d probably only be equal at expiration, because recall that the value of an option (put or call) is the sum of its intrinsic value and its time value. So at expiration the time value is zero. It may also help for you to calculate the profit to the long position for a few other stock prices besides the maximum payoff. Returning to my initial example, breakeven still occurs at a stock price of $95, but profit will vary based on how far the price drops: 1) Stock price drops from $100 to $50: Profit = $100-$5-$50 = $45 2) Stock price drops from $100 to $30: Profit = $100-$5-$30 = $65 3) … You’ve got the gist of it though
Lola… it might help you if you open a simulation account on investopedia.com. you can trade options to see how they work and it will really help you to really understand this stuff. that is what i did and the derivatives section wasnt all that difficult (for L1 obviously). I didnt have to memorize any of these formulas because i understood how they worked, and could figure it out on the fly…
nola, I got one of those, but it’s not being put to good use, as you can probably tell That’s a great suggestion though! thanks to all who helped. hired, I’ve said this before, but your examples really help get the message across.
I second nola’s suggestion. If you get used to trading options then the derivative questions on options are a piece of cake.