Profit Calculation in Call and Put Options: A Comprehensive Guide for Beginners

Understanding the profit calculation in derivatives, specifically call and put options, is crucial for any investor or trader. This article will guide you through the process of calculating gains or losses in these financial instruments, using a practical example based on Reliance's lot size. By the end of this article, you will be equipped with the knowledge to accurately calculate your potential profits or losses in both call and put options.

Introduction to Call and Put Options

Call and put options are financial derivatives that give the holder the right to buy (call) or sell (put) an underlying asset at a predefined price (strike price) within a specified time frame. Let's first understand the basics of each:

Call Option: A contract that gives the holder the right, but not the obligation, to buy an underlying asset at a specified price (strike price) within a predefined time frame. Put Option: A contract that gives the holder the right, but not the obligation, to sell an underlying asset at a specified price (strike price) within a predefined time frame.

Profit Calculation in Call Options

Let's consider an example where Reliance's lot size is 500 units. The current market price (CMP) is 2 rupees per unit. Suppose you decide to buy a call option on Reliance when the market price is 2 rupees, indicating that you have the right to buy at 2 rupees per unit. Later, if the market price rises to 3 rupees per unit, you can exercise your call option to buy the asset at 2 rupees and then sell it at 3 rupees, resulting in a profit.

Example Calculation

The process of calculating the profit in a call option follows these steps:

Cost of Buying the Call Option: The cost of buying the call option is the strike price multiplied by the lot size. In our example, the cost is:

Strike Price Lot Size 2 rupees/unit 500 units 1000 rupees

Selling the Asset after Exercising the Call Option: If the market price rises to 3 rupees per unit, you would exercise your call option and buy the asset at 2 rupees and sell it at 3 rupees, making a profit of 1 rupee per unit.

Selling Price Lot Size 3 rupees/unit 500 units 1500 rupees

Calculating the Profit

To determine your profit, you need to subtract the cost of buying the call option from the amount you receive from selling the asset:

Profit Selling Price Lot Size - Cost of Buying the Call Option

Profit 1500 rupees - 1000 rupees 500 rupees

Therefore, your profit from this call option would be 500 rupees.

Profit Calculation in Put Options

Now, let's move on to put options. The concept is similar, but the outcomes and actions differ. If the market price falls, you can exercise your put option to sell the asset at a predefined price and then buy it back at an even lower price, making a profit.

Example Calculation

Assume you have a put option on Reliance with a strike price of 1.8 rupees per unit. If the market price falls to 1.6 rupees per unit:

Cost of Buying the Put Option: The cost of buying the put option is the strike price multiplied by the lot size. In this case:

Strike Price Lot Size 1.8 rupees/unit 500 units 900 rupees

Buying the Asset after Exercising the Put Option: If the market price drops, you would exercise your put option and sell the asset at 1.8 rupees and then buy it back at 1.6 rupees, making a profit of 0.2 rupees per unit.

Buying Price Lot Size 1.6 rupees/unit 500 units 800 rupees

Calculating the Profit

Similar to the call option, you need to subtract the amount you spend on buying the asset from the cost of buying the put option to determine your profit:

Profit Cost of Buying the Put Option - Buying Price Lot Size

Profit 900 rupees - 800 rupees 100 rupees

Hence, your profit from this put option would be 100 rupees.

Key Points to Remember

Call options are exercised when the market price is above the strike price. Preliminary calculations should be done to determine the cost of buying the option and the selling price after exercising the option. In the case of put options, the calculation is similar but involves the market price falling below the strike price.

Conclusion

Understanding the profit calculation in call and put options is essential for any investor or trader looking to manage risks and maximize profits in the financial market. By following the steps outlined in this article, you can accurately determine your potential gains or losses in these financial instruments. Keep these calculations in mind and make informed decisions in your trading activities.

Keywords

call option, put option, profit calculation