OPTION ARITHMETIC

An option can be used either as a speculation, as a means of enhancing returns, or

as a hedging vehicle. There is a sunk cost paid to acquire an option that is equal to its
price. The upside ' potential from a long position in an option is large, but the downside
limit is no greater than the price paid for it. However, the price that the underlying stock
must attain before one breaks even on an option is affected by the price paid for the
option.

1. Call Arithmetic
The figure below depicts the intrinsic value of a call option (C) with strike price (K)
as a function of the price of the underlying stock (S). The solid line indicates the "intrinsic
value" of the option (the value at the expiration date excluding any time value). This
intrinsic value equals the difference between the price of the stock and the strike price of
the call if the stock's price is above the strike price of the call; it is equal to zero otherwise:
C = S - K If the calculation produces a positive value; otherwise C = 0.
The dashed line indicates how the actual value of a call option varies with the price
of the stock. This value is usually greater than the intrinsic value of the option because of a
time value component.
When the price of the underlying stock is above the strike price of the call, the call
is said to be "in the money"; when stock's price is below the strike price of the call, the call
is "out of the money". When the stock's price is equal to the strike price, the option is "at-
the-money".
If a call option is purchased at a price C, the analysis of the profit/loss potential is
illustrated in the figure below. The maximum loss is the price paid for the call that will
occur if, on the expiration date, the price of the stock is at or below the strike price of the
call. The call buyer will break even (earn zero profit) if, on the expiration date, the stock's
price is K+C; a profit is earned on the call if the stock rises above the breakeven level.
Example: Stock Price 24
Strike Price 20
Call Price 6
Owning the stock, the investor could experience a profit or loss of (let us say) 10
points. Owning the call, the investor can experience a loss of no more than 6 points
because, if the stock closes at or below 20 by the expiration date, the call will be worthless
and all that can be lost is the 6 points paid for the call. The upside potential is unlimited. If
the stock rises to 34, for example, the call will be worth 14 producing a retum of 133%
(unannualized) on the $6 purchase price of the call. However, because a price of 6 was
paid for the call, the investor does not break even until the stock reaches 26. The
ownership of a call limits the downside risk, offers unlimited upside potential, provides
significant leverage, but raises the breakeven price, relative to having an outright
ownership position in the stock. This profit/loss analysis is depicted by the solid line in the
figure below.
Writers of naked calls face an opposite set of potential outcomes. Given the same
call data as above, the writer of the call can sell it for 6. If the option is exercised, the
writer must sell 100 shares of the underlying stock to the holder of the call for $20 per
share. If the stock's price is below this strike price on the expiration date, the holder of the
call will not exercise the option. In this case, the writer's profit will equal the entire 6 point
premium received from selling the call. If the stock's price rises above the exercise price,
the holder of the call will exercise it. The writer of a naked call then must buy the stock in
the open market at its market price and sell it to the call holder at 20. This gives the writer
of the naked call an unlimited potential loss. However, because the call writer receives a
premium of 6, the breakeven point is equal to a stock price of 26 (K+C). This profit/loss
analysis is illustrated by the dashed lines in the figure below.

2. Put Arithmetic
Put options enable the holder to profit from a decline in a stock's price below the
strike price of the option. The figure below depicts the intrinsic value of a put option (P)
with strike price (K) as a function of the price of the underlying stock (S). The solid line
indicates this "intrinsic value" of the option. This value equals the difference between the
strike price of the option and the price of the stock if the stock's price is below the strike
price; otherwise the intrinsic value of a put is zero.
P = K - S as long as the calculation produces a positive value; otherwise P = 0.
 Note that the maximum value that a put option can attain is its strike price (if S =
0, K-S= K). The dashed line depicts the actual value of a put option, which will be greater
than its intrinsic value because of a time value component.
The analysis of the profit/loss potential of a naked put at price P is illustrated
below. As with a call, the maximum loss that can be sustained by a put holder is the price
paid for the option. This occurs if the stock closes at or above the strike price of the option
on the expiration date. The put owner will break even if the stock's price is K-P on the
expiration date.
Example: Stock Price 24
Strike Price 20
Put Price 2
If the stock closes at or above the strike price (K = 20), the put will expire
worthless and the owner of the put will suffer a maximum loss of the 2 points paid for the
put. If the stock closes below the strike price by its expiration date, the put will be worth
the difference between the strike price and the stock's price. However, because a price of 2
was paid for the put, the investor does not break even until the stock reaches 18.
Ownership of a put offers leveraged profitability if the stock's price drops; this upside
potential is limited, however. This profit/loss analysis is depicted by the solid line in the
figure below.
Writers of naked puts face an opposite set of results. They can earn a maximum
profit equal to the premium for which they sold the put if the stock stays above the strike
price until expiration. However, a loss will not occur until the stock's price drops below K-P
(18 in this case). Their maximum exposure to a loss is P-K (18 points in this case), which
occurs if the stock becomes worthless.
Notice that both the buyer and the writer of a naked put have limited profit and
loss potentials, whereas the buyer of a naked call has an unlimited profit and limited loss
potential, while the seller of a naked call has limited profit and unlimited loss potential.