Finance

Importance of Break-even point in Options Trading

Just as a break-even point is crucial for earning profits in a business, it is important in the trading world as well. Break-even is that point where the revenue earned is equal to cover up the costs incurred. Any additional amount earned over and above the break-even point is profits.

While trading in the stock market, you may calculate your costs by adding the buy price, cost of brokerage, and GST. The amount earned after recovering these costs is the profits earned in the trade.

Options trading

Trading in futures and options are popular among investors for hedging and speculating. Investors trade in options, in particular, to protect themselves against fluctuations in the price of a share.

Options trading is a contract between two parties wherein the buyer gets the right, but not the obligation, to buy at a set price (also known as strike price) on or before a particular date (also known as exercise date). There are two types of options, namely, call options and put options. The right to sell the security, say a stock or index, is known as a put option, whereas the right to buy the security is known as a call option.

Achieving break-even in options trading

While trading in options, say call options, the buyer gets the right to buy the security at the set price till the option expires. The options buyer provides a fee to the options seller, for taking such an obligation. The set price, in such a case, becomes the basis of break-even for both the buyer and seller.

For the buyer, the set price plus the premium is the break-even point. Besides, it is also necessary to add other costs incurred such as the cost of brokerage, GST, or any other associated fee. Any amount earned after covering these costs earns a profit for the buyer. For example, assume the set price of the call option is INR 1000 and the buyer pays other costs amounting to INR 50. This means that the security has to cover INR 1050 before expiry in order to break-even.

In case you are trading in put options, the break-even is calculated as the strike price minus the premium paid. For example, if the investor pays INR 50 for a 300-put option of XYZ stock, this means the put buyer can sell shares of XYZ at INR 300 per share till the option expires. The break-even price here, therefore, is INR 300 less than INR 50, or INR 250. If XYZ stock is currently trading for INR 200, the put owner may buy the stock at that value and sell it at INR 300 by exercising the put. The profit earned in this case is INR 50. i.e. INR 300 minus INR 250 (INR 200 paid towards the cost per share plus INR 50 paid towards premium).

Options are an effective type of derivatives to combat market fluctuations. It is however imperative to have a deep understanding of related trading and investment practices in order to earn good profits.