Today we’re going to look at the short call option payoff graph. This is designed for beginners so they can develop a basic understanding how to read the payoff graphs.
We’ll look at:
Contents
- Short Call Option Basics
- Call Option Payoff Graph
- Different Scenarios At Expiration
- Payoff Graph At Interim Dates
- How Changes In Volatility Impact The Payoff Graph
- Short Call Option Payoff Summary
Short Call Option Basics
A short call is quite easy to understand but is not recommended for beginners due to the unlimited loss potential.
A call option is a contract between a buyer and seller.
The contract seller will have the obligation to sell a certain stock at a certain price, up until a certain date (called the expiration date).
What this means is that up until the contract expires, the seller of a call has the obligation to sell the stock at the agreed price.
Call Option Payoff Graph
Understanding payoff graphs (or diagrams as they are sometimes referred) is absolutely essential for option traders.
A payoff graph will show the option position’s total profit or loss (Y-axis) depending on the underlying price (x-axis).
Here is an example:
What we are looking at here is the payoff graph for a short call option strategy.
In this example the trader has sold a 345 strike call for $4 per contract (or $400 for a standard option contract representing 100 shares).
The premium collected of $400 is the most the trade can profit. That occurs at an underlying stock price of $345 and below.
Above the strike price of 345, the line slopes downward as the payoff falls in proportion with the stock price.
The lines crosses into loss at a certain point when the stock price rises above the breakeven point.
The breakeven point is simply the strike price plus the premium received. In this case it would be:
If the premium received had been slightly higher at $5, then the breakeven price would be $350
Different Scenarios At Expiration
Four different scenarios can occur at expiration for a short call trade.
1. Underlying stock price is below the strike price
This is the ideal scenario that the trader was hoping for. Ideally the stock would be a long way below the breakeven price.
If the underlying stock price is below the strike price at expiration, the call option will expire worthless. The profit for the trade will be equal to the premium received and no more.
In our example, this would be $4 per contract or $400in total.
Think about it this way, if the stock is trading below $345 at expiry, it makes no sense for the opposite party (the buyer) to exercise the option to buy the stock at $345 when he can buy at cheaper price in the market.
2. Underlying stock price is equal to the strike price
The stock price ending right at the strike price at expiration would be incredibly rare, but it could happen.
In this case it also doesn’t make sense the opposite party (the buyer) to exercise the option because he could just buy the stock in the market for the same price without having to pay the exercise fees.
3. Underlying stock price is above the strike price but below the breakeven price
If the stock is above the strike price at expiration, the trader may think he has a loss, but unless the stock gets above the breakeven price, it will not end in a loss.
For example, let’s say the stock ends at $347. The $345 strike short call option has $2 of loss and will be assigned.
But, the $2 of loss is less than the $4 premium received, so in this scenario, even though the short call option has some loss at expiration, the trader has profit $2 per share.
4. Underlying stock price is higher than the breakeven price
If the underlying stock price is above the strike price at expiration, the short call option will be assigned.
The loss for the trade will be equal to the strike price minus ending stock price plus the premium received.
Or, if they don’t want to be assigned shares, they can buy the call back before expiration.
Let’s assume the stock finished at $360, the loss is equal to $345 – $360 + $4 = $11 per share.
The bad thing about a short call is that the loss is unlimited, the higher the price rises, the higher the loss in a linear way.
Payoff Graph At Interim Dates
So far, we’ve only considered the payoff graph at expiration. The payoff graph at interim dates will look very different and will be impacted by factors such as time decay and implied volatility.
Calculating the profit and loss at expiration is quite simply, using excel or even in your head if you are half decent at maths.
Calculating profits and losses at interim dates is much more complex and requires more advanced software than just Excel.
Any decent options broker will have the ability to show option profits and losses at interim dates.
The below short call option payoff is from Interactive Brokers.
The short call option was an AAPL 125 strike call sold for $2.60 per contract or $260 in total. The breakeven price at expiration is $127.6 (strike price plus the premium received).
The blue line shows the expiration payoff that you are now familiar with and the purple line shows what is known as a “T+0” line.
T+0 simply means, what does the trade look like as of today?
Notice that the breakeven price as of today is the current AAPL price. This makes sense because we just sold the call so wouldn’t expect to have made or lost any money yet.
Notice also that losses occur much before the expiration breakeven price and below 125, the profits are not the maximum profit.
As time goes by, the interim line slowly moves towards the expiration line.
Here’s how the payoff diagram is estimated to look at one week before expiration.
See how the purple line is now much closer to the expiration payoff line?
Most brokers will be able to provide this sort of graphical information for you.
I also like to use Option Net Explorer because they can show multiple interim date lines.
Looking at the payoff graph below, notice that there are three interim lines – T+0, T+11 and T+22. This gives the trader a good appreciation of how the trade will progress over time after 11 days and 22 days.
How Changes In Volatility Impact The Payoff Graph
Changes in implied volatility will not have any impact on the payoff graph at expiration, but it will impact the interim dates.
A short call strategy has negative vega, meaning that it will benefit from an decrease in implied volatility after placing the trade.
This AAPL trade example has vega of -12 which means that for every 1% drop in implied volatility, the trade will make $12 with all other factors being equal.
The opposite is true if implied volatility rises.
Let’s take a look at how a 20% drop in volatility impacts the interim lines.
Notice that the expiration line hasn’t changed at all, but the interim lines have all moved higher.
Now, let’s see how the diagram changes assuming a 20% rise in volatility. All the interim lines have dropped significantly.
With a short call strategy, delta is the main driver of the trade, but we can clearly see that big changes in implied volatility will also affect the trade.
Short Call Option Payoff Summary
You should now be intimately familiar with the short call option payoff graph. Let’s summarize some key points.
- Short call options are a bearish strategy with limited upside and unlimited risk
- The maximum profit is equal to the premium received for the short call
- The breakeven price is equal to the strike price plus the premium received
- The position will gain value as expiration approaches due to time decay
- As a negative vega trade, decrease in implied volatility will help the trade, but only at interim dates
If you’re still having trouble or want to learn more about these concepts, you can check out this 12,000 word beginners guide to options.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
