Breaking Even with Options

A call option provides you with profits similar to long stock, whereas a put option provides you with profits similar to short stock. This makes sense given your rights as an option holder, which allow you to buy or sell stock at a set level. There is one slight difference between stock rewards and option rewards: Options require an initial premium payment that you must consider when identifying potential gains.

There are three key value points for option trades: break even, in the money (ITM), and out of the money (OTM). So, calculating potential option rewards requires you to add option premiums to call strike prices and subtract option premiums from put strike prices to come up with a price known as the position’s breakeven level. A stock’s price must

• Rise above the breakeven for call option profits to kick in.

• Fall below the breakeven for put option profits to kick in.

In each case, this results in profits that are slightly less than your stock profits.

A stock’s breakeven point is your purchase price when buying stock or your sell price when shorting a stock. As soon as the stock moves away from this price, you have gains or losses.

Call option

Purchasing a call option gives you rights to buy stock at a certain level. As a result, the option increases in value when the stock moves upward. After a stock moves above your call option’s strike price, the option has intrinsic value which increases as the stock continues to rise. Calls with strike prices below the price of the stock are referred to as ITM.

For a call position you own to be profitable at expiration, it must remain above the strike price plus your initial investment. At this level, option premiums will minimally equal your cost when you bought the call.

The breakeven for a call option is:

Call Breakeven = Call Strike Price + Call Purchase Premium

After a stock’s price is at the option’s breakeven level, it can continue to rise indefinitely. Your call option can similarly rise indefinitely until expiration. As a result, call option profits are considered to be unlimited, just like stock.

An option’s moneyness is determined by the option type and the price of the underlying stock relative to the option strike price. Call options with a strike price that is below the stock price are OTM, and their premium is all time value. After the stock moves above the strike price, it is referred to as ITM and has intrinsic value along with the time value.

Put option

Purchasing a put option gives you rights to sell stock at a certain level. As a result, the option increases in value when the stock’s price moves downward. When a stock moves below your put option’s strike price, the option has intrinsic value, which increases as the stock continues to fall. Puts with strike prices above the price of the stock are referred to as ITM.

For a put position you own to be profitable at expiration, it must remain below the strike price minus your initial investment. At this level, option premiums will minimally equal your cost when you bought the put.

The breakeven for a put option is:

Put Breakeven = Put Strike Price – Put Purchase Premium

When a stock is at the option’s breakeven level, it can continue to fall until it reaches zero. Your put option can continue to increase in value until this level is reached, all the way to its expiration. As a result, put option profits are considered to be high, but limited, just like a short stock.

Call options have risks and rewards similar to long stock, whereas put options have rewards that are similar to short stock. Put option risk is limited to the initial investment. The reason your rewards are similar rather than the same is because you need to account for the premium amount when you purchased the option.