For a business owner, knowing their breakeven is a really important deal. In fact, their livelihood depends on it.
In basic terms, the breakeven is the point at which the revenue coming in matches the total of all costs going out. Any money received on top of these costs becomes the company’s profit.
While businesses might have a myriad of costs to account for, working out the breakeven on a share trade is a much simpler task. You take your entry (or buy) price, add on the cost of brokerage, and the amount to cover GST.
Once the share price exceeds this, the trade is in profit. Well…on paper anyway. Obviously nothing is locked in until you close out your position.
For an option trader, though, calculating the breakeven becomes a bit more involved. However, it’s something that a trader needs to get their head around if they want to trade options.
Like anything to do with options, it’s easy to get lost in a world of jargon. If you break it down into its individual components, though, you’ll quickly get the hang of it.
The breakeven of a call option
To illustrate the breakeven, we’ll use a call option. As the definition goes, a call option gives the buyer the right to buy the underlying shares, at the strike price, up until the option expires. For taking on this obligation, the option seller receives a fee, called the premium, from the option buyer.
The strike price represents the agreed price at which the call option seller must hand over the underlying shares to the option buyer, if the buyer exercises the option.
This strike price becomes the basis from which to work out the breakeven, for both the option buyer and seller. However, the movement of the underlying share price has an opposite effect on their respective breakeven points.
For the buyer, the breakeven of an option is the strike price plus the premium. On top of this, they need to add the cost of brokerage, the ASX Clearing Fee and any GST. However, to make it easier to understand, let’s just use the strike price and premium for our calculations.
If the strike price of a call option is $5.00, and the buyer pays a 50 cent premium, then the breakeven is $5.50. Meaning that the underlying share price has to get to $5.51 before expiry, for the option buyer to make any money.
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One way to check out the breakeven is by using a payoff diagram. While they might be confusing at first glance, they are a really important tool for trading options. Take a look at the following diagram:
Payoff diagram for a call option buyer
The diagram shows a call option with a $50 strike price that trades at a $2.00 premium. The vertical axis represents the profit/loss for the trade; the horizontal axis represents the share price. The arrow plots the profit or loss in relation to the share price at expiry.
Typically, an option contract is for 100 shares. For the option buyer, at $2.00 premium per share (per contract), that means their cost is $200. Looking at the above diagram, this is represented by the -$200.
With a $50 strike price, if the share price stays at $50 or below at expiry, the option buyer will lose their $200. Yes, they could still exercise their option if they wanted to, but there wouldn’t be any point — they could buy the shares cheaper in the market.
However, as the share price moves past $50 and heads higher, it starts to absorb some of the cost of the option. Once the share price hits $52, the trade reaches its breakeven — the share price increase matches the cost of the option (plotted as zero profit on the vertical axis).
If you continue to follow the arrow, you can see that for every $1.00 the share price increases above the breakeven point, the value of the option increases by $100. That is $1.00 multiplied by the number of shares per contract (100). So at $54 — as per the dotted line on the diagram — the profit is $200.
From the option seller’s side, although their breakeven is calculated the same way (strike price plus the premium), the opposite happens. They receive $200 from the option buyer. But this is the most they can receive for the trade.
As the trade hits the breakeven, which is $52 in this example, for every dollar the share price moves higher, they are giving up $1.00 in potential profit. If the share price was to rocket away, this becomes really significant.
Remember that the option seller has obligations — they must hand over the shares at the strike price if the option is exercised. Even if the shares are trading much higher. For receiving the premium, they are giving up potential profit.
Why the breakeven is important
While the breakeven is important in share trading, it becomes even more so in options trading. And the reason all revolves around one central theme: time.
If you think about buying shares, while you’d like your shares to go up straight away, there really isn’t any time limit. Once you own them, you can simply wait for them to take off. However, as all options have expiries, the clock is always ticking. And that’s why the breakeven is so important for options.
You’ve got to be confident that the share price will hit the breakeven point ($52 in the above example) before the option expires. Otherwise, there’s no point in doing the trade. Remember that an option ceases to have any value the moment it expires.
That’s also why there’s a direct relationship between the premium of an option and the strike price. The less chance of the share price hitting the breakeven point before the option expires, the less the option buyer will be prepared to pay for it.
While buying a call option can have unlimited profit potential, you’ve also got to be realistic. You’ve got to be confident that the share price will not just hit, but exceed, the breakeven before looking to place the trade. If not, then it’s best to keep your money in the bank until you find a trade that will.
Editor, Total Income
Ed note: The above article was originally published in Money Morning.