Risk Management Applications of Options Strategies

Call Option Profits and Losses

• Max loss for buyer of call is the premium
• Breakeven for buyer of a call is strike PLUS premium
• Profit potential is unlimited for call holder - loss of the writer is unlimited
• Call holder will exercise WHENEVER stock price exceeds strike price at the expiration date - might even make a net loss, but a smaller net loss
• Greatest profit a call writer can make is the $5 premium
• Zero sum game, always

Put Option Profits and Losses

• Max loss for buyer is again the premium
• Max gain for buyer is strike LESS premium - this is also max loss for the seller
• Breakeven is at strike minus option premium
• Greatest possible profit for writer is the premium
• Also a zero sum game

Put buyers think things are overvalued, call buyers think they are undervalued.

Writing Covered Calls - writing a call while holding the stock.  You think the price is not going up anytime soon, so you write calls to profit in the meantime.  You trade potential upside for the premium.

• If stock finishes below original price, writer's loss will be offset by the premium
• If stock finishes below STRIKE price, option is still worthless and writer gets GAIN PLUS PREMIUM up until the strike price 
• If stock closes above strike price, the max gain is the same
• Maximum loss is the full stock price, less the premium you gained
• You are basically betting that the gains will not be as big as the call buyer thinks they will be

Protective Puts - buying a stock and also buying a put option.

• Cuts your downside loss but leaves potential upside alone
• Max loss occurs anywhere below the strike
• You do not profit until stock rises enough to cover your premium (breakeven = strike plus premium)
• Note: This is the same diagram as a long call!