SignUp to Newsletter

The 4 Basic Option Risk Profiles

4 Risk Profiles

Long Call

Buying a Call

  1. belief that stock will rise (bullish outlook)
  2. risk limited to premium paid
  3. unlimited maximum reward

Short Call

Writing a Call

  1. belief that stock will fall (bearish outlook)
  2. maximum reward limited to premium received
  3. risk potentially unlimited (as stock price rises)
  4. can be combined with another position to limit the risk

Long Put

Buying a Put

  1. belief that stock will fall (bearish outlook)
  2. risk limited to premium paid
  3. unlimited maximum reward up to the strike price less the premium paid

Short Put

Writing a Put

  1. belief that stock will rise (bullish outlook)
  2. risk unlimited down to the Strike Price less the premium received
  3. maximum reward limited to the premium received
  4. can be combined with another position to limit the risk

Long Call Risk Profile

We already know that a call option is the right to buy an asset.  Logically, this suggests that the call option risk profile direction will be similar to that of buying the asset itself.  So let's have a look at an example:

Stock Price $56.00
Call Premium $7.33
Exercise Price $50.00
Time to Expiration 2 months

Remember that:

Buying gives you the Right

  • Buying a call option gives you the right, not the obligation to buy an underlying instrument (eg a share).
  • When you buy a call option you are not obligated to buy the underlying instrument - you simply have the right to do so at the Strike Price.
  • Your maximum risk, when you buy an option, is simply the price you paid for it.
  • Your maximum reward is uncapped.

Short Call Risk Profile

For every call that you buy, there is someone else on the other side of the trade.  The seller of an option is called an option writer.  Logic and common sense tell us that the option seller's risk profile must be different to that of the option buyer.

Stock Price $56.00
Call Premium $7.33
Exercise Price $50.00
Time to Expiration 2 months

Remember that we already discussed the implications of selling an option - here's a reminder:

Selling (naked) imposes the Obligation

  • Selling a call obliges you to deliver the underlying asset to the option buyer.
  • Selling options naked (ie when you have not bought a position in the underlying instrument or an option to hedge against it) will give you an unlimited risk profile.  The continuous downward diagonal line is generally a bad sign because it means unlimited potential risk.
  • Combined with the fact that you are obliged to do something, this is not an ideal strategy for the inexperienced, however it can be combined with other positions to create a new strategy.

Long Put Risk Profile

So, now you know what long and short calls look like, let's look at the risk profile of a put option.

We already know that a put option is the right to sell an asset.  Logically, this suggests that the put option risk profile direction will be the opposite to that of calls or buying the asset itself.  So, again, let's have a look at an example:

Stock Price $77.00
Put Premium $5.58
Exercise Price $80.00
Time to Expiration 4 months

Remember that:

Buying gives you the Right

  • Buying a put gives you the right, not the obligation to sell an underlying instrument (eg a share).
  • When you buy a put you are not obligated to sell the underlying instrument - you simply have the right to do so at the Strike Price.
  • Your maximum risk, when you buy an option, is simply the price you paid for it.
  • Your maximum reward is uncapped.  With long puts your reward is uncapped to the downside, ie the strike price less the put premium.  In this example that is: $80.00 - $5.58 = $74.42.

For every put that you buy, there is someone else on the other side of the trade.  The seller of a put option is will have a different risk profile to that of the put option buyer.

Short Put Risk Profile

Stock Price $77.00
Put Premium $5.58
Exercise Price $80.00
Time to Expiration 4 months

Remember that we already discussed the implications of selling an option - here's another reminder for puts:

Selling (naked) imposes the Obligation

  • Selling a put obliges you to buy the underlying asset to the option buyer.  Remember, when you sell a put, you have sold the right to sell to the person who bought that put.
  • Selling options naked (ie when you have not bought a position in the underlying instrument or an option to hedge against it) will give you an unlimited risk profile.  The continuous downward diagonal line is generally a bad sign because it means uncapped risk.
  • Combined with the fact that you are obliged to do something, this is not an ideal strategy for the inexperienced.

Risk Profiles Summary

You have now learned what the essential risk profiles look like and what they mean to you in terms of maximum risk and reward.

Profile Description Max Risk Max Reward Breakeven
Buy Asset purchase price uncapped purchase price
Sell Asset uncapped short sale price short sale price
Buy Call call premium uncapped strike price plus call premium paid
Sell Call uncapped call premium received strike price plus call premium received
Buy Put put premium strike price less put premium paid strike price less put premium paid
Sell Put strike price less put premium received put premium received strike price less put premium received