This Picture Is Worth a Thousand Words for Options Traders

Options are often misunderstood. Some traders view them almost like a lottery ticket. This view is not altogether wrong. There are times when an option trading for just a few cents climbs by more than 10,000%. This is why cheap options are often used in insider trading schemes. And, because regulators know that trick, that strategy leads to many prosecutions for insider trading.

Put options can also lead to large payoffs during market crashes. In that case, cheap options gain value as markets crash. This is also a rare event and traders have suffered large losses using strategies that benefit from crashes, since the options almost always expire worthless.

These scenarios explain the way options are misunderstood. They can provide large gains when unusual events occur, but they often result in small losses when the event fails to unfold during the options lifetime.

Less understood are options strategies that provide a high probability of a small payoff. Great fortunes can be made by patient investors who are willing to pursue a large number of small gains with limited risk. One example of this idea is shown below.

This figure is known as an option payoff diagram. These diagrams are an important tool for options traders because they show the potential gains and rewards. The chart above is taken from the Options Industry Council web site. You can create your own charts for any strategy at that site.

In the chart, the stock price is shown in the horizontal axis. The profit or loss on the trade is shown in the vertical axis. In this chart, the break-even level is at $60. The trader enjoys a profit at any stock price above $60 and records a loss at any price below $60. The chart highlights the limited risk on the trade along with the fact that there is a maximum amount of profit possible. This is shown as the red line moves horizontally after the price rises or falls below certain levels. As the chart shows, no matter how high the stock price rises, the profit is capped. Likewise, the red line indicates no matter how far the price falls, the dollar size of the loss is also capped.

The chart above is the actual risk and reward of a strategy known as a “bull call spread.” This is a strategy that benefits from an increase in the stock price. As the payoff diagram shows, the risk is capped, in this case at less than $100 per contract. The potential gains are also capped in this case at a little less than $200 per contract. In advance, traders know the risk and reward and can decide whether or not the trade is right for them.

We will detail this strategy and others in future articles. For now, we are focusing on the payoff diagram which will be used to explain the risks and rewards as we review strategies.

In the chart above, the stock is trading at $60. As a trader, you are bullish on the stock. But, you may have limited capital. Buying a stock, especially one with a high share price, can tie up a large amount of capital. For small investors, trades requiring a large amount of capital limit their ability to diversify. There are a number of options strategies that can provide exposure with only limited capital.

In this case, we want exposure to the upside. One way to do that is to buy a call option. For this option, there is a $60 call trading for about $1.02. An options contract covers 100 shares, so this trade would require capital only $102, or $1.02 times 100 shares.

With the call option, you benefit from the upside in the stock. However, you may also be concerned that the stock market is overbought on a technical perspective. Overbought means prices have moved up sharply in a short amount of time. Overbought markets often sell off, giving back part of the gains. This increases the risk of the market. To buy the option, you will risk $102, ignoring commissions as we will do throughout this article. A call spread can reduce the cost of the trade and limit the risk.

A bull call includes two call options which both expire at the same time but they have different strike prices. The strike price is the price the call can be exercised at. To open a bull call, a trader buys one call and sells another call. The call they sell will have a higher strike price than the one they bought. By selling the call, they reduce the amount of money required to buy the call. This reduces risk in dollar terms. Selling the call also caps the upside potential of the trade.

In this example, the trader sells a call with a strike price of $62.50. They receive $0.22 in premium for the trade. Combined, they spent $102 to buy a $60 call and received $22 to sell a $62.50 call. The total cost is $80 and that is the maximum risk.

At expiration, the stock price will either be above the higher priced option (above $62.50), below the lower priced option (below $60), or between those two prices. Let’s look at each of those cases assuming the price is $65, $61 or $55.

If the stock is at $65, both calls have value at expiration. The $60 call you bought will have a value of $5. The $62.50 call you sold will have a value of $2.50. To close the trade, you would sell the $60 call for $5 and buy the $62.50 for $2.50. This transaction would net $250. You paid $80 to open the trade leaving a profit of $170. This is the maximum gain on the trade.

If the stock is at $55, both call options will be worthless. In this case, you lose $80, the amount of money paid to open the position. This is always the maximum loss on the trade.

If the stock is at $61, between the two strike prices, the call you bought at $60 is worth $1. The call you sold at $62.50 is worthless. Selling to close the $60 call results in receiving $100. Because you paid $80 to open the trade, you have a small gain of $20 on the trade. If you had not sold the call, this trade would have resulted in a small loss.

The payoff diagram showed all of this information at a glance. These diagrams allow traders to visualize the risk and return potential of the trade in advance.

In future articles, we will review options trading strategies and at times we will include the options payoff diagram to highlight important characteristics of the trade. While a $170 gain may not seem appealing to traders, the amount of capital needed to open the trade could be less than $100. This is a potential gain of more than 100% on the required investment. Because many of these strategies involve a small outlay of capital, they could be beneficial to small traders.

Remember, you can create payoff diagrams for any strategy at the Options Industry Council web site, https://www.optionseducation.org/strategies_advanced_concepts/strategies.html. This will highlight risk, reward and required capital.

These strategies could allow small traders to profit from the large moves stocks often make after announcing earnings. They could help small traders benefit from market volatility associated with news events like Federal Reserve meetings or unemployment reports. And, in all cases, risks will be defined and capped in advance.