From time-to-time, we either receive great questions or see interesting ones asked online in various forums. Instead of only replying 1:1, we will start sharing the most relevant insights here.
Question: I’m new to option trading and I have some questions regarding how profit is calculated? If I buy call option at ATM 525 (1425 lot size) for a premium of 8000, and the stock price goes up to 540. Do I make profit in the difference of current and strike price i.e., (540-525=15) Profit = 15x1425 = 21375? Or do I make money for change in the premium for the strike price?
If the contract hasn't expired, you will look at the current bid price of the call (to sell to close the long call) to help determine your profit. The potential profit is lot size x (current bid price per contract - price you paid per contract) less transaction costs.
The price of an option is derived from the intrinsic value and extrinsic value. The intrinsic value is the difference between the underlying price and the strike price. When you buy an option that is at-the-money (ATM) or out-of-the-money (OTM), there will be no intrinsic value. Since ATM and OTM contracts have a price despite no intrinsic value, you are paying for extrinsic value - or the time value associated with the option and the volatility of the underlying. The more time until expiry, the higher the time value portion of extrinsic value. The higher the volatility of the underlying, the higher the volatility portion of extrinsic value.
On expiration, extrinsic value goes to 0. The only value is intrinsic value.
For long calls: If the underlying is above the strike price, the profit is (underlying - strike - premium paid per contract) x lot size less transaction costs. If the underlying is at or below the strike, the payoff is 0 so your loss is the premium paid less transaction costs.
For long puts: If the underlying is below the strike price, the profit is (strike - underlying - premium paid per contract) x lot size less transaction costs. If the underlying is at or above the strike, the payoff is 0 so your loss is the premium paid less transaction costs.