Understanding Returns

Understanding Returns

Call Option

Let's take the following call option and use it as our example:

PodCall WETH:USDC 700 Dec 31st

	Description
underlying asset	WETH
strike asset	USDC
option type	Call
exercise type	European
strike price	$700
spot price	$500
expiration	31 Dec 2020
current day	21 Nov 2020
premium	$20

In this example, the contract refers to a call option for WETH:USDC that can be exercised only at expiration on the 31 Dec 2020 as it is a European option with a strike price of $700, where the options market price, also called as premium, is $20. In other words, this option buyer paid $20 to have the option to buy the WETH for $700 from the option seller, who has an obligation to sell the underlying asset, once the option is exercised, regardless of the spot price the asset at the expiration.

The following scenarios could happen:

1) WETH Spot price on the 31 Dec 2020 = $900

In this case, it would be profitable for the option buyer to exercise the call option as the asset would be sold for $200 discount from the prices in the market. In this situation, the option is in-the-money (ITM). Once exercising the option, the option buyer would have had the following (simplified) profit:

Profit = Spot price - Strike price - Premium

Profit = 900 - 700 - 20

Profit = $180

The same would happen to any spot price above the strike price + premium.

2) WETH Spot price on the 31 Dec 2020 = $500

In this case, it doesn't make sense for the option buyer to exercise his option as it is possible to buy the underlying asset (WETH) for a cheaper price in the market. In this situation, we say that the option is out-of-the-money (OTM). As the option buyer paid the premium, we can say that he had a loss limited to the option's price, which is $20.

Loss = - $20

Conclusion

It is possible to see that for call options, the loss is limited to the premium, and the profit is unlimited as the price of the underlying asset increases, as shown in the graph below:

Put Option

Let's take the following call option and use it as our example:

PodPut WETH:USDC 400 Dec 31st

	Description
underlying asset	WETH
strike asset	aUSDC
option type	Put
exercise type	European
strike price	$400
spot price	$500
expiration	31 Dec 2020
current day	21 Nov 2020
premium	$30

In this example, the contract refers to a put option for WETH:USDC that can be exercised only at expiration on the 31 Dec 2020 as it is a European option with a strike price of $400, where the options market price, also called as premium, is $30. In other words, this option buyer paid $30 to have the option to sell the WETH for $400 to the option seller, who has an obligation to buy the underlying asset, once the option is exercised, regardless of the spot price the asset at the expiration.

The following scenarios could happen:

1) WETH Spot price on the 31 Dec 2020 = $300

In this case, it would be profitable for the option buyer to exercise the put option as the asset would be sold for $100 more than the current price in the market. In this situation, the option is in-the-money (ITM). Once exercising the option, the option buyer would have had the following (simplified) profit:

Profit = Strike price - Spot Price - Premium

Profit = 400 - 300 - 30

Profit = $70

The same would happen to scenarios where the spot price is below the strike price until the asset's price reaches 0.

2) WETH Spot price on the 31 Dec 2020 = $600

In this case, it doesn't make sense for the option buyer to exercise the option as it is possible to sell the underlying asset (WETH) for a higher price in the market. In this situation, we say that the option is out-of-the-money (OTM). As the option buyer paid the premium, we can say that he had a loss limited to the option's price, which is $30.

Loss = premium

Loss = - $30

Conclusion

It is possible to see that for put options, the loss is limited to the premium, and the profit is restricted/limited until the spot price of the underlying asset decreases until zero, as we can see in the graph below: