Cash Flows on Options

There are two types of options. A call option gives the buyer of the option the right to buy the underlying asset at a fixed price, whereas a put option gives the buyer the right to sell the underlying asset at a fixed price. In both cases, the fixed price at which the underlying asset can be bought or sold is called the strike or exercise price.

To look at the payoffs on an option, consider first the case of a call option. When you buy the right to sell an asset at a fixed price, you want the price of the asset to increase above that fixed price. If it does, you make a profit, since you can buy at the fixed price and then sell at the much higher price; this profit has to be netted against the cost initially paid for the option. However, if the price of the asset decreases below the strike price, it does not make sense to exercise your right to buy the asset at a higher price. In this scenario, you lose what you originally paid for the option. Figure 1 summarizes the cash payoff at expiration to the buyer of a call option.

Figure 1: Payoff on Call Option

Figure 1: Payoff on Call Option

With a put option, you get the right to sell at a fixed price, and you want the price of the asset to decrease below the exercise price. If it does, you buy the asset at the exercise price and then sell it back at the current price, claiming the difference as a gross profit. When the initial cost of buying the option is netted against the gross profit, you arrive at an estimate of the net profit. If the value of the asset rises above the exercise price, you will not exercise the right to sell at a lower price. Instead, the option will be allowed to expire without being exercised, resulting in a net loss of the original price paid for the put option. Figure 2 summarizes the net payoff on buying a put option.

Figure 2: Payoff on Put Option

Strike Price

Strike Price

If asset value>strike price, you lose what you paid for the put.

^ Price of Underlying Asset

With both call and put options, the potential for profit to the buyer is significant, but the potential for loss is limited to the price paid for the option.

Retirement Planning For The Golden Years

Retirement Planning For The Golden Years

If mutual funds seem boring to you, there are other higher risk investment opportunities in the form of stocks. I seriously recommend studying the market carefully and completely before making the leap into stock trading but this can be quite the short-term quick profit rush that you are looking for if you am willing to risk your retirement investment for the sake of increasing your net worth. If you do choose to invest in the stock market please take the time to learn the proper procedures, the risks, and the process before diving in. If you have a financial planner and you definitely should then he or she may prove to be an exceptional resource when it comes to the practice of 'playing' the stock market.

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