A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset.
This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X–axis and the profits/losses on the Y–axis.
In this section we shall take a look at the payoffs for buyers and sellers of futures and options.
Payoff for futures
Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited.
These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.
Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty
portfolio.
When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses.
Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio.
When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.
Options payoffs
The optionality characteristic of options results in a non-linear payoff for options.
In simple words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited.
For a writer, the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited.
These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying.
We look here at the six basic payoffs.
Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price,S4 it is purchased, the investor is said to be “long” the asset.
Payoff profile for seller of asset: Short asset
In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and buys it back at a future date at an unknown price S4 Once it is sold, the investor is said to be “short” the asset.
Payoff profile for 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, he makes a profit.
Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option.
This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X–axis and the profits/losses on the Y–axis.
In this section we shall take a look at the payoffs for buyers and sellers of futures and options.
Payoff for futures
Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited.
These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.
Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty
portfolio.
When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses.
Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio.
When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.
Options payoffs
The optionality characteristic of options results in a non-linear payoff for options.
In simple words, it means that the losses for the buyer of an option are limited, however the profits are potentially unlimited.
For a writer, the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited.
These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying.
We look here at the six basic payoffs.
Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price,S4 it is purchased, the investor is said to be “long” the asset.
Payoff profile for seller of asset: Short asset
In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and buys it back at a future date at an unknown price S4 Once it is sold, the investor is said to be “short” the asset.
Payoff profile for 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, he makes a profit.
Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option.