Stock market options are derivative contracts that allow a trader to profit from a rise or decline in a share price. The advantage of using options is that a trader commits a much smaller amount of money to take a position in a certain stock. For example, 100 shares of Apple at $380 per share costs $38,000. A call option for the same number of shares good for the next few months might cost $1,000 to $2,000, depending on the option specifics. Option contracts on lower prices stocks can be purchased for a few hundred dollars and offer thousands in profit potential.
Call Option Breakeven
Select a specific call option for which to calculate the breakeven. A call option is defined by the underlying stock, price of the underlying stock at which the option can be exercised -- strike price -- and the expiration date. The price of the call option is based on these factors plus the volatility of the underlying stock. As an example, use a call option on IBM, assuming the current share price is $171.50. A call option with a strike price of $175 expiring in two months has a price of $5.60.
Add the call option strike price to the call option premium. In the example from the previous step, the strike price of $175 plus the call option price of $5.60 gives a total of $180.60. This price is the no-commission breakeven share price.
Calculate the brokerage commissions per share to buy the option, exercise the contract and sell the stock shares to lock in the profit. For the example, assume the broker charges $8.50 for an options trade, $25 for an options contract exercise and $7 to buy or sell shares. The commissions total is $40.50. Each option contract is for 100 shares of the underlying stock, so in this case the commission per share would be 40.5 cents. If two call options had been purchased, the commission rate would be about 20 cents per share.
Add the commission charges per share to the no-commission breakeven share price to obtain a true breakeven price. In the example, for one IBM call option, $180.60 plus commissions of $0.405 equals $181. The selected call option has a breakeven price of $181. Buying this particular option would be profitable if the share price of IBM moved above $181 before reaching the expiration date.
Put Option Breakeven
Select a put option to purchase to profit from a declining share price. Put options also have a strike price and expiration date. For the IBM example, a put option with a $175 strike price is quoted at $9.
Subtract the option price from the strike price for the no-commission breakeven price. In the example, $175 minus $9 equals $166.
Subtract the commissions per share from the calculated price to calculate the final breakeven. In the example, $166 minus $0.40 gives a put option breakeven of $165.60. A purchased put option would be profitable if the IBM share price drops below this level.
- The cost of an options contract is 100 times the price. The example IBM call option would cost $560 per contract plus commissions.
- Options have intrinsic value if they are in-the-money, which means the share price is above the strike price. A put is in the money if the shares are below the strike price. The example put option is in the money, but the share price must decline enough to cover the cost of the option to be profitable.
- A put or call that reaches expiration out of the money will expire worthless. The risk of buying options is limited to the premium paid. However, the limited time frame until an option expires means the underlying stock must move enough in the right direction within the time frame for an options trade to be profitable.
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