If you’re new to options trading, one of the most important things you need to understand is how profit is calculated. Otherwise, you can quickly find yourself making trades without really knowing what you’re getting into. It doesn’t have to be a complicated process. In this guide, we’ll walk you through the basics of options pricing and show you how to calculate your potential profit.
How Profit Is Calculated In Options Trading Videos
What is an Option?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Options can be either calls or puts. A call option gives the buyer the right to buy the underlying asset, while a put option gives the buyer the right to sell the underlying asset. The price at which the buyer can buy or sell the underlying asset is called the strike price. The date on which the option expires is called the expiration date.
How are Options Priced?
The price of an option is determined by a number of factors, including:
- The price of the underlying asset
- The strike price of the option
- The time to expiration
- The volatility of the underlying asset
- The interest rate
The Black-Scholes model is a mathematical formula that is used to calculate the theoretical price of an option. However, the actual price of an option may differ from the theoretical price due to factors such as supply and demand.
How to Calculate Your Potential Profit
To calculate your potential profit from an options trade, you need to know the following:
- The number of contracts you are buying or selling
- The premium you are paying or receiving
- The strike price of the option
- The expiration date of the option
Once you have this information, you can use the following formula to calculate your potential profit:
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Potential profit = (Selling price – Purchase price) x Number of contracts
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For example, let’s say you buy 100 call options with a strike price of $100 and an expiration date of one month. You pay a premium of $5 per contract. The current price of the underlying asset is $105.
If the price of the underlying asset rises to $110 before the option expires, you can exercise your options and sell the underlying asset for a profit. Your potential profit would be:
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Potential profit = ($110 – $105) x 100 = $500
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However, if the price of the underlying asset falls below $100, your options will expire worthless and you will lose your entire investment.
