The 'optionality' characteristic of Options results in a non-linear payoff for them.
In simple terms, this means that the losses for the buyer of an Option are limited, but the profits are potentially unlimited.
For a writer (seller), the payoff is exactly the opposite. Their profits are limited to the Option premium, but their losses are potentially unlimited.
By using combinations of Options and the underlying, these non-linear payoffs are utilized to generate various other payoffs. Here are six basic payoffs from which various trading and investing strategies are derived:
Payoff profile of the buyer of an asset: Long asset
In this basic position, an investor buys the underlying asset, such as ABC Ltd. shares, for Rs. 2220, and sells it at a future date at an unknown price. Once purchased, the investor is said to be "long" the asset.
Payoff profile for the seller of an asset: Short asset
In this basic position, an investor shorts the underlying asset, like ABC Ltd. shares, for Rs. 2220, and buys it back at a future date at an unknown price. Once sold, the investor is said to be "short" the asset.
Payoff profile for the buyer of Call Options: Long Call
A Call Option gives the buyer the right to buy the underlying asset at the strike price specified in the Option. The profit/loss that the buyer makes on the Option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, they make a profit. The higher the spot price, the higher the profits. If the spot price is less than the strike price, the loss is the premium paid for buying the Option.
Payoff profile for the writer (seller) of Call Options: Short Call
A Call Option gives the buyer the right to buy the underlying asset at the strike price specified in the Option. The writer of the Option charges a premium for selling it. The profit/loss for the buyer depends on the spot price of the underlying. Whatever profit the buyer makes is the seller's loss. If, upon expiration, the spot price exceeds the strike price, the buyer exercises the Option, resulting in losses for the writer. If the spot price is less, the writer keeps the premium.
Payoff profile for the buyer of Put Options: Long Put
A Put Option gives the buyer the right to sell the underlying asset at the strike price specified in the Option. The profit/loss for the buyer depends on the spot price of the underlying. If, upon expiration, the spot price is below the strike price, they make a profit. The lower the spot price, the higher the profit. If the spot price is higher than the strike price, the loss is the premium paid for buying the Option.
Payoff profile for the writer (seller) of Put Options: Short Put
A Put Option gives the buyer the right to sell the underlying asset at the strike price specified in the Option. The writer of the Option charges a premium for selling it. The profit/loss for the buyer depends on the spot price of the underlying. Whatever profit the buyer makes is the seller's loss. If, upon expiration, the spot price is below the strike price, the buyer exercises the Option, resulting in losses for the writer. If the spot price is higher, the writer keeps the premium.