Options: Break-even point.

Knowledge about the concept of break even is very important in finance. In F & O’s too, identification of break even price is very crucial to take the right decisions.

WHAT IS BREAK EVEN?

Break even point is that point at which you make no profit or no loss. It is the minimum rate of return that your investment should generate in order to maintain a no profit-no loss situation. However, No profit /Loss is not the point where your purchase price matches with the sale price. Your break-even point must include the recoupment of all fees, commissions and other expenses associated with the purchase and sale of the investment.

BREAK EVEN POINT FOR OPTIONS.

When you try to identify the break even point for options there are three factors to be considered –

  • Strike price
  • Option premium
  • Commission and transaction costs.

The commission part will be different from one broker to another. So make sure you understand how your broker charges commission on options.

BREAK EVEN FOR CALL HOLDER.

To find out if your call trade has potential for a profit, apply the following formula:

  • Strike price + Option premium cost + Commission and transaction costs = Break-even price

So if you’re buying an RIL December call with strike price at Rs 150 that sells for Rs 7.50 premium and the commission is Rs 15, your break-even price would be-

  • Rs 150 + Rs 7.50 + 15 = Rs 172.50 per share.

That means,  to make a profit on this call option, the price per share of RIL has to rise above Rs 172.50 per share. Effectively, the potential loss of a call holder is restricted to the premium paid and transaction costs. Ie, Rs 22.50 per share.

BREAKEVEN FOR PUT HOLDER.

To find out if your put trade has potential for a profit, you have to apply the following formula:

  • Strike price - Option premium cost – Commission and transaction costs = Break-even price

So if you’re buying a put on RIL December call with strike price at Rs 150 that sells for Rs 7.50 premium and the commission is Rs 15, your break-even price would be-

Rs 150 – Rs 7.50 – 15 = Rs 127.50 per share.

That means that to make a profit on this put option, the price per share of RIL has to drop below Rs 127.50 per share. The more it drops, the more profitable your position becomes. Effectively, the potential loss for a put holder is restricted to the premium paid plus brokerage on transaction.

So, just because an option is trading in-the-money does not mean that you will make sure profits out of it. The stock price has to cross the breakeven point to result in real profits.

In our previous post, we said that an option gains value only when it’s in-the-money. In all other cases, the option does not have any value. The question is what would happen if the price of options is not in line with the theory? In such cases, arbitrage opportunities will open up. Before discussing more about options arbitrage, there is one question that needs a clarification. Is there any relationship between the value of a call and that of a put ? To answer that, we need to look at one more theoretical topic on options- Put call parity. Understanding this relationship is necessary to get into grips with options arbitrage.

You may like these posts:

  1. Options: Moneyness.
  2. Options: Choices of action.
  3. Options: Premium

5 Responses to “Options: Break-even point.”

premsunderdas

July 9, 2012 at 8:30 am

Very clear schooling

Sunder

July 13, 2012 at 12:16 pm

Right,Good to see these useful info here..Thanks a lot for sharing them with us….

J Victor

July 15, 2012 at 10:10 am

Thanks :)

Abhay

January 16, 2014 at 10:26 pm

Thank you very much Victor for sharing in amazingly simple language.

sanjay

November 2, 2016 at 9:32 pm

Hi.. Very good series of posts.. loved them.. from my understanding, will the premium paid by the buyer (during call or put) always end up with seller, whether the buyer is in a in-the-money or out-of-money position..??

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