Series 7: 5.3.3.6 Calculating Gains And Losses

5.3.3.6  Calculating Gains and Losses

Investors often trade their options rather than exercise them. When a trader opens a position and then later closes it without exercising the option, the gain or loss is the difference in the premiums of the opening and closing positions. The premium is the price you pay or receive for your option. When you close out your position, the difference in the two prices is your profit or loss. For example, if you buy a long call for $2 per share, and you later close out the same position when it is trading for $5 per share, the difference of $3 per share is your profit. Spreads are only slightly more complicated in that the difference in premiums applies to the trading of two different options.

Remember that premiums are composed of both intrinsic and time value. An option that is in the money has intrinsic value; an option that is out of the money has none. Time value erodes as an option gets closer to expiration. Time value increases as it gets closer to the strike price.

A spread option in which both positions expire in the money has no time value, but has maximum intrinsic value. A spread option in which both positions expire out of the money has neither time value nor intrinsic value. By closing out a spread before it expires, an investor can sometimes increase his profits by capturing some of the time value in the two premiums.

For the exam, you may need to know when it is good for the premiums to be getting farther apart (widening) or to be getting closer together (narrowing).

Purchasers of debit spreads prefer their positions go in the money and they want the value of their premiums to widen. Credit spread investors want their positions to expire out of the money and the