In options trading, the term “break-even price” describes the price that the underlying shares of an options contract must reach by the option’s expiration in order for the owner of the option to avoid losing money on its purchase. This article reveals formulas and explores basic frameworks that buyers of calls and puts can use to both calculate and conceptualize the break-even points of options trades.
There are only a handful of ways a trader who is long an option can break-even on a trade once the option’s value falls below its original purchase price. The two primary ways consist of the value of the underlying security must move in a direction and magnitude that compensates for the deficit, or the implied volatility of the underlying asset must increase to a point where the option premium returns to its original value.
As an option’s expiration date draws closer, the premium contributed by implied volatility diminishes — eventually to a point of zero. It is at that point that the question of whether a trader has broken even on his long-option strategy comes down to a single fact: whether or not the price of the underlying at expiry has exceeded the original premium paid plus the strike price.
Let’s begin with an analogy to answer why an options trader benefits from break-even analysis. In the world of business, a competent manager must always be aware of both the sales and cost figures that ensure an enterprise breaks even. When managers have a strong grasp of these numbers, they experience greater confidence that they can manage their enterprises in a way that results in a profit.
The world of options trading is no different. A trader who purchases a call or a put benefits by knowing which factors influence the value of the option. By becoming familiar with these variables, traders can improve their odds that an option trade results in profit or — in the event an options trade goes bad — that losses are minimized.
Before illustrating how to calculate the break-even point for an options trade, it’s important to familiarize ourselves with a concept that options traders call the "payout structure". As we will see through the two examples that follow, the payout of a long option strategy differs depending on whether the trader is long a call or a put.
A “long call strategy” refers to a position where a trader buys a call option with the expectation that the value of the call will rise at some point in the future.
In most cases, when you go long a call option, you are betting that the price of the underlying stock will rise soon. However, this doesn't mean that the risk you are taking on when you enter a long call trade is limited to the directional movements in the price of the underlying stock. When it comes to risk, there is more you have to consider when you are long a call option than when you are simply long shares of a stock.
When you buy a call option, you are exposed to risk along four principal dimensions:
In other words, when you go long a call option, you do so with the expectation that either the price of the underlying stock will rise or its implied volatility will increase -- or both things will occur. You also expect that when either or both of these scenarios take place, it will result in a repricing of the call options that recovers any value lost due to time decay and any value lost to the spread (in the event you sell back your options prior to expiration).
So if you are considering opening a long call position it is critically important to monitor inputs like Delta, Vega, Theta, and the bid-ask spread. The following example will demonstrate why.
Let’s imagine a trader buys a call option to buy Zoom Video Communications Inc (ZM) at a strike price $140. The date is February 15th, and the contract is set to expire 31 days later on March 18th. Currently, ZM stock trades at $146.90, and the value of the option is priced at $17.49.
Now let’s also imagine the underlying ZM stock trades flat between now and the expiration date. In other words, on the day of March 18th, ZM settles at the same price that it traded on February 15th, The call is considered “in the money” — a term used to describe an option whose strike price is less than the price of the underlying shares. Therefore the value of the call option at expiration is equal to value of the underlying shares minus the value of its strike price.
Now let’s do the math with actual numbers: if the underlying ZM shares settle at $146.90 and the strike price of the call option is $140, then each call option is now worth $6.90 at expiration.
The value of March 14 ZM calls with a $140 strike has dropped from $17.49 to $6.90 in the span of 31 days. Our trader has unfortunately lost $10.59 worth of option premium — more than 60% of his original investment.
Had the trader bought ZM stock on February 15th, instead of a call option, he would not have lost any money. So what just happened? Why did the value of the call option decline so much even though the price of ZM stayed the same? Let’s revisit the construct we introduced in preceding paragraphs to answer this question.
Whenever a trader goes long a call option, he is betting that either the price of the stock will increase, or that the implied volatility will rise (or a combination of both outcomes) — and that these outcomes will materialize within a specified timeframe. But let's take things a step further and actually break down how an option is valued.
An option has two primary types of value: intrinsic value and time value. Intrinsic value represents the value an option would be worth assuming its expiration were taking place now. Time value is what's left after subtracting the intrinsic value from the premium, namely the price you pay for the option. The time value is positively correlated with the implied volatility of the underlying stock and with the amount of time remaining until expiration.
In the case of a call option, the intrinsic value is represented by the price of the underlying stock minus the price of the call option. The time value of the option depends on both the implied volatility of the stock and on the amount of time remaining until expiration. The more volatile a stock is, and the longer the amount of time until expiration, the greater the probability that the stock will settle at a price that is significantly distant from its current price.
The break-even price on a long-call position is the strike price plus the option premium.
Strike Price + Premium at Date of Purchase = Break Even Price at Expiration
Therefore in the Zoom Interactive example, we can calculate the price at which ZM shares would need to settle at expiration in order to for our long-call trade to break even by adding the following inputs into the formula:
$140 - $17.49 = 157.49
This strategy is the directional opposite of a long-call strategy. Instead of betting on an imminent rise in the price of an underlying asset, a trader who goes long put options usually expects the price of the underlying asset to soon decline. By putting on this position, a trader goes short delta and long vega. Let's take a closer look at what this means through the example below.
Imagine a scenario where on February 17th, the stock of Peloton Interactive Inc (PTON) trades for $30.59. At this time, a trader can buy a put option with a strike price of $30 that expires on March 18 for a premium of $2.62. This option gives the owner the right to sell PTON at $30 per share.Therefore it will retain some of its value as long as the underlying trades below a price of $30.
Now let’s imagine that on March 18th, the price of PTON stock settles at $25. The value of the put option will have risen to $5. We know this is true because the put in our scenario allows the option-holder to sell the stock of PTON at a price of $30 per share while at the same time, the same shares trade on the open market at a price of $25. Since the put was purchased for an initial price of $2.62, and has risen to a value of $5, this trade nets a profit of $2.38 per option.
The break-even price on a long-put position is the strike price less the option premium.
Strike Price - Premium at Date of Purchase = Break Even Price at Expiration
Therefore in the Peloton example, we can determine the price at which PTON shares would need to settle at expiration in order for our long-put strategy to break even by adding the following inputs into the formula:
$30 - $2.62 = $27.38
Any option that is purchased on an exchange can be freely sold at any time before its expiration. In the event that the option-holder has broken even on his long-call or long-put trade, he can simply close out the position by selling it. The profit from the trade equals the market value of the option minus the initial value of the option, net of any brokerage fees.
As a general rule, when a trader holds a call option that has broken even to the date of expiration, the trader’s brokerage firm will assign the number of shares stipulated by the options contract. The trader can then liquidate these shares immediately for profit equivalent to the value of the shares minus the strike price of the options.
Of course, things become a bit trickier if you break-even with a long put strategy and hold till expiration. In the event that you are long an in-the-money put that expires, and lack the underlying shares in your trading account, your broker will request that you first buy the shares before you exercise the option. Therefore, in such a scenario, the process is much simpler if you already hold both the puts and the equivalent underlying shares at the time of the option’s expiration.
If you new to options, it's important to understand that the strike price and the break-even price of an option are not equivalent. There are in fact two key differences:
It is crucial that any trader considering initiating a long-call or long-put strategy understand how to calculate the price an underlying security must achieve in order for an options position to break even at the time of expiration. By knowing this price, a trader can get a better handle on whether a long-option trade is likely to result in a profit or loss before putting money at risk. And as traders become more skilled, they can incorporate research methods that calculate historical probabilities into their trading process so in order to calculate the odds a security will reach the break even price before an option contract expires. That of course, is what Tradewell is all about.
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