This guest article was written by Zoe Fiddes who is the Head of Sales at ORE
In the article ‘Directional Trading Using Options’, you were introduced to two types of options – Calls and Puts. In this article, I will explain how option payouts are calculated and how you can use them to assess trades.
An option will payout at expiry if the option’s reserved rate can ‘beat’ the market. The reserved rate is also known as the ‘strike’ rate. For a Call option to payout, the market rate at expiry must be higher than the strike, and for a Put to payout, the market rate at expiry must be lower than the strike. But, what determines the size of the payout?
Payout at expiry is determined by two things: First, the difference between the market rate and the strike, and second, the deal size (or amount). Below is a EUR/USD Call option with a reserved rate of 1.09 buying 100,000 Euros over the next 7 days. At expiry, if EUR/USD is above 1.09, the option will pay-out, and if the pair is at or below 1.09, there is no payout.
Payout at Expiry Calculation
If the EUR/USD is trading at 1.15, the option holder’s reserved price (or strike) to buy at 1.09 ‘beats’ the market by $0.06 (that is, 1.15 – 1.09). Therefore, the holder receives $0.06 payout for each 1 EUR traded, which is a total payout of $6000 (0.06 x 100,000 EUR).
The below ‘scenario table’ shows an option’s payout over a range of EUR/USD rates. When the EUR/USD is above a strike of 1.09, payout = (Market rate – Strike} x Amount. When EUR/USD is at or below the strike rate, there is no payout.
|EUR/USD Market Rate at Expiry||Option Payout|
The next step is to calculate the profit or loss of the option trade. This entirely depends on the original amount you paid for the option. If you look at the EUR/USD Call option above, you see it costs $500 to buy. Profit or loss is simply the Payout minus the amount paid (the open premium). The scenario table below shows all profit (or loss) values over the range of EUR/USD rates at expiry. When EUR/USD is 1.15 (top row of the table), the payout is $6000 and the Open Premium is $500. Hence, profit is $5500 ($6000 – $500). We can then continue this calculation for all the EUR/USD market rates.
|Oil market price||Option Payout||Open Premium||Profit/Loss|
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By evaluating the table, it becomes very clear that if EUR/USD rises, profit will grow and it has the potential to be unlimited. Yet, if the EUR/USD goes down, a loss is incurred but that loss is limited to the $500 originally paid for the option with no stop-loss involved.
Now, we can take the values of the scenario table and plot the ‘profit or loss’ against a range of EUR/USD rates. This creates a ‘scenario chart’ as shown below. The horizontal axis is the EUR/USD rate and the vertical axis is the profit or loss. As EUR/USD rises above 1.09 the profit line is increasing and as the pair falls below 1.09 the loss is limited.
Option Trade Profit/Loss over a range of EUR/USD rate scenarios:
This is a classic long (buy) call option trade, which can be used to profit from an uptrend in markets including FX, precious metals, and oil.
When trading via an online platform, you won’t have to do the profit and loss calculations. The platform does it for you! You can utilise a Scenario Payout tool, a chart and table indicating the trades’ profit levels, break-even points, and maximum risk over a range of market rates.
In Part 4 of The Options Game, Zoe Fiddes explains what the ‘moneyness’ of an option means.
The Options Game (previous articles):