This basic concept can improve your knowledge as an options trader.
What is the break even point of an option?
When you buy an options contract, you are purchasing the right to buy or sell 100 shares of stock at a specific strike price. As an options trader, you have the benefit of leverage.
When you purchase 100 shares of stock without an option, you know exactly what price you paid per share.
However, when you buy a call option to purchase 100 shares, you must account for the premium you paid when calculating your cost basis.
When you buy a call option and exercise it, the breakeven point will be your cost basis of the shares.
Break even point formula
Call option break even formula:
- Strike price + premium paid
For example, if you buy a $100 strike call option for $1.00 per share in premium, your cost basis if you exercise the option would be $101.
Therefore, if you decide to exercise this option, you would own 100 shares of the stock at $101 per share, including the premium for the option of $100.
Put option break even formula:
- Strike price – premium paid
For example, if you buy a $100 strike put for $1.00 per share in premium, your cost basis would be $99.
When you buy a put option, you are betting on the stock moving down or hedging your portfolio.
Therefore, if you exercise a put option, you will be short 100 shares at your break even point of $99 per share in this example.
What if you don’t plan to exercise?
You are not obligated to exercise and take the shares when buying options. Instead of exercising, you can simply sell the contract to close it.
Options have the potential to make you a lot of money but buying them is a low-probability game. You will likely lose more than you win, but this is fine if you have a positive EV trading system.