How to Calculate Profit in Options Trading

Options traders employ several trading strategies, but they all have the same objective: to make a profit. It’s possible to make money with options trading, and knowing how to calculate profitability can give you an edge. Knowing how this calculation works can tip you off on optimal times to enter and exit positions. You will know how the stock price has to move for your options contract to break even and generate profits. This article will dive into options trading calculations.

Options Trading Profit

The profits from an option trade depend on your entry price and how the underlying asset’s price moves. Traders with long calls and short puts hope the stock’s price will increase in the near term. Traders holding onto long puts and short calls hope for the opposite. These traders look for stocks that may decrease in the near future and enter bearish positions. The strike price, expiration date, volatility and underlying asset’s price movement impact profitability. 

Once you get to know the basics, it gets easier. You can get started with a straightforward approach to options trading if you want to learn how these derivatives work.

What Is Option Formula

An option formula helps traders gauge the breakeven price point(s) and profitability range for each option position. It’s a good idea to start with the basics: individual call and put contracts. For more complex options trading strategies, there are multiple breakeven prices and a profitability range tucked between those breakeven prices. Understanding the basics of individual call and put contracts can help you grasp more advanced setups in the future.

Call Option

Call options gain value as the underlying stock’s price rises. The call option’s profitability depends on the strike price and premium. Assume a stock trades at $50 per share, and a trader buys a $55 call for a $2 premium. With this information, it is possible to make a few calculations.

Intrinsic value = Underlying Stock’s Current Price - Call Strike Price

Intrinsic value = $50 - $55

Intrinsic value = $0 (any calculation that produces a negative number has no intrinsic value. -$5 is the gap between the current price and strike price)

An intrinsic value of $0 reveals that the option contract is currently out of the money. A positive number indicates the contract is in the money. However, this does not represent your breakeven price. You paid a premium to obtain this call, which represents the time value of the contract. Time value is any amount paid that exceeds the intrinsic value. If an option has a $3 intrinsic value, and you pay a $4 premium, the option has a time value of $1 (4-3=1). 

Put Option

Put options appreciate when the underlying stock’s price decreases. They are the inverse of calls. For this example, assume a stock is priced at $40 per share, and the trader buys a put with a $30 strike price. Because this contract is further out of the money, the premium is only 50 cents for this example. Performing intrinsic value and time value calculations will reveal the breakeven price. 

Note that for a put’s intrinsic value, you are deducting the underlying stock’s current price from the put’s strike price. These numbers are put in reverse for the call option intrinsic value calculation.

Intrinsic value = Put Strike Price - Underlying Stock’s Current Price

Intrinsic value = $30 - $40

Intrinsic value = -$10

A negative intrinsic value means the put is out of the money. A positive number indicates the put option is in the money. An intrinsic value of zero tells traders that the option is at the money.

Now that the intrinsic value has been calculated, a trader can use that number to determine an option’s time value.

Time Value = Put Premium – Intrinsic Value

Time Value = $0.50 - (-$10)

Time Value = $0.50 + $10 ← a negative minus a negative becomes a positive

Time Value = $10.50

A positive time value implies the put option is unprofitable at the moment. A negative number indicates profitability, while zero represents breakeven. An options trader who buys this put needs the stock to hit $29.50 at expiration to break even. Any cent below $29.50 represents profit.

Examples of Calculating Profits in Options Trading

Wondering how profits work for calls and puts? These examples will demonstrate how to calculate breakeven points for the key options positions: long calls and puts, along with short calls and puts.

Buying a Call Option

Assume a trader buys a call with a $100 strike price for a $3 premium. The stock is valued at $95 per share at the time of the purchase. A trader can use the intrinsic value calculation to determine that the value is negative $5. That’s because the underlying price ($95) minus the strike price ($100) results in negative $5. 

Subtracting the intrinsic value from the call premium results in a time value of $8. 

$3 - (-$5) becomes $3 + $5, which provides the time value of $8. A stock would have to reach $103 for the trader to break even.

But what happens if the stock reaches $101 or $106? If the stock reaches $101 at expiration, the trader will be $2 short, representing a $200 loss. A $106 price at expiration results in a $3 surplus from the $103 breakeven price. The $106-per-share price at expiration translates into a $300 gain.

Selling a Call Option

Some traders believe a stock will stay flat or not rise substantially. Selling calls lets investors net premiums and can help if your portfolio goals revolve around cash flow. Many of these traders want the call option to expire worthless. Assume a stock trades at $20 per share, and the trader believes the stock has no chance of trading above $23 per share. This trader sells a covered call and receives a $1 premium.

The intrinsic value is the difference between the underlying price and the strike price. In this case, it’s negative $3, implying the stock is out of the money. The trader wants the stock to stay out of the money for the length of the contract. 

The time value of the option is $4 because it’s the difference between the premium and the intrinsic value (1 - (-3) = 4).

This means the trader’s breakeven price is $24 per share. If the stock closes at $23.40 per share at expiration, the trader will have to sell 100 shares at $23 per share. However, the option’s premium puts the trader up $60. If shares rise to $27 per share, the trader loses $3 per share, or $300. Selling at $23 per share and receiving a $1 premium at the start of the trade only results in a $24 per share breakeven price.

If the stock rises to $22 per share or stays at $20 per share, the short call will expire worthless. The trader will no longer be obligated to buy 100 shares at $23 per share and gets to keep the premium.

Buying a Put Option

Want to position yourself for some upside if a stock’s price declines? Put options enable this setup. Assume a trader buys a put with a $180 strike price for a $10 premium. The underlying asset currently trades at $200 per share. 

Deducting the underlying stock’s price from the strike price indicates a negative $20 intrinsic value (180 - 200= -20). It’s possible to deduct negative $20 from the premium to determine the time value. In this example, the time value is $30. The calculation is below:

Time value = $10 premium - (-$20 intrinsic value) = $30

The stock needs to reach $170 per share to breakeven. If the stock closes at $175 per share at expiration, the put’s intrinsic value increases to $5 and is in the money. However, the $10 premium offsets the gains and turns the position into a loss. The negative $5 time value converts into a $500 loss. 

If the same stock closes at $150 per share at expiration, the trader will gain $2,000 from the put option. There is a $20 gap between the $150-per-share closing price and the $170 breakeven price. While this wouldn’t be favorable for a long call holder, the trader with the put profited from this trade.

Selling a Put Option

Selling put options lets you benefit from rising stock prices. Assume a trader does not believe a stock valued at $50 per share will fall below $45 per share. This trader sells a put and receives a $1.50 premium. The intrinsic value is negative $5, and the time value is $6.50. 

The trader needs the stock to stay above $45 per share to realize the maximum profit. However, the breakeven price is $43.50. If the stock hovers at $44 per share, the trader will realize a profit but also have to sell 100 shares at the $45 strike price. Any number below $43.50 represents a loss.

Walk into Every Trade Knowing Your Breakeven Price

If you want to trade options, it’s important to know the breakeven price. Identifying this price reveals the necessary stock price for profitability. Some options trading platforms provide this for you and automate the calculations. Even if you receive this information, it’s good to know how these calculations work. Knowing the inputs can help you become a better options trader and view breakeven prices with a new perspective.

Frequently Asked Questions