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Options Trading: The Basics of Derivatives

Posted On July 12, 2018 12:12 pm
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The following graph illustrates the other side of the trade, the profit-loss graph for the seller of the call:

The seller collects the premium, which is the maximum profit and occurs as long as the option expires with the stock price below $40. Above $40 per share, the seller has the obligation to sell the stock to the call buyer at the strike price and begins to lose dollar for dollar. The graph indicates that the seller is making the bet that the stock will not go up, or at least not very much before the expiration of the option.

A put option gives the owner the right to sell the stock at the strike price anytime before the expiration of the option. The following graph illustrates the return profile at expiration of a long (bought) put on DuPont stock:

In this case, the buyer of the put pays a $2 per share premium for the right to sell the stock at the strike price of $40 until expiration. This premium is the maximum loss no matter how high the stock goes. The buyer of the put is making the bet that the stock price will drop significantly before expiration.

To complete the expiration graphing of options, the following illustrates the return profile for the seller of the put:

A subtle fact shown by these graphs is that the real value of options is to provide investors, traders, and speculators alike with flexibility. Options break apart into components the risk-return profile of the underlying asset. Combined with the underlying asset, various combinations of options can be used to create a desired return profile.

The following graph illustrates the return profile of long (bought) DuPont stock:

To illustrate that options break apart the risk-return profile of a stock, we can re-create the profile for long stock by using a combination of long calls and short puts of the same strike:

 Related: Is a Reckoning Coming for Tech Stocks? 

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About author

Steve Smith
Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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