Options – Calls and Puts Payoffs

Let’s look at the payoff in the first case where Karthik buys calls of IDBI at Rs 145 for 3 months. Suppose he pays a premium of Rs 5 for each share. Let’s say that each calls contract includes 100 shares of IDBI. Hence Karthik will have to pay Rs 5 * 100 = Rs 500. Let’s look at the payoff at different prices of IDBI at the expiry (at the end of 3 months)

Buy Call

The graph shows the maximum Karthik can lose is the premium paid, i.e. Rs 5 for every share that is the in the contract. This means for a call contract that has 100 shares of IDBI as underlying asset, Karthik will lose maximum of Rs 500. This is also called ‘Buy Call” contract payoff.

Buy Put

Let’s take the second case where Karthik buys the right to sell Aurobindo Pharma shares. In this case too, let’s assume that Karthik pays Rs 20 a share as premium. Hence to buy one call contract consisting of 100 shares, Karthik will pay Rs 2000 as premium. Let’s look at the payoff at different prices of Aurobindo Pharma at the expiry (at the end of 3 months). Remember in this case, Karthik has bought the right to sell IDBI Aurobindo Pharma at Rs 1200 a share at the expiry. He will only get benefit if the prices go below Rs 1200.

In this case too, Karthik’s maximum loss is the premium, i.e. Rs 20 per share while the gain is almost unlimited (well… in this case, the maximum gain will be 1200 – 20 = 1180 per share because the share price cannot go below 0).

What happens when Karthik sells call and put? These are reverse of the above payoff graphs. Let’s take a look.

Sell / Write Call:

Suppose Karthik sells the call. This means Karthik is selling the right to buy IDBI at Rs 145 a share in 3 months. Karthik will be paid premium of Rs 5 a share for this. At the end of the 3 months, the buyer of call will only exercise his option when the price of IDBI goes up. This means Karthik will lose when the price of IDBI goes up. Let’s take a look at the payoff.

Here the gain for Karthik is limited to Rs 5 a share while losses are unlimited.

Sell /Write Put:

Let’s take the example of Karthik selling the put (i.e. right to sell) of Aurobindo Pharma at 1200 in 3 months at a premium of Rs 20 a share. Remember that in this case, the buyer has the right to sell. He will only sell when the prices go below. Hence Karthik will lose when the prices go down. Let’s take a look at the payoff.

In this case, the payoff of Karthik is limited while the losses are unlimited.

In our next discussion, we will take some typical cases where calls and puts are traded. It is important to know what drives sellers of Calls and Puts despite exposing themselves to the unlimited risks.

Pankaj Priyadarshi

Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).