In the above examples we have seen how strike price is compared with the prevailing price in the market to arrive at a decision of either exercising the Option or letting it expire worthless.
But in real life, one needs to adjust for the premium paid or received as well.
Example: if I have bought a call option with a strike price of INR 50 and the prevailing price of the security on maturity date is INR 60 – I will exercise my Call Option and buy at INR 50, making a profit of INR 10 (not adjusting for the security lot size). Now consider this: If I had paid a premium of INR 11/- to buy this call option, would I still be exercising this call option – or would I just leave it to expire?
I shall just leave it to expire because I will only make a profit if the price of this security in the market is above 61/- as my strike price is 50 and premium is 11, hence ONLY of the price of the security in the markets is anything above 61, will it make economic sense for me to exercise this option.
Break-even point:
In the above example:
Strike Price is INR 50/-
Premium is INR 11/-
Hence the price of 61 – is called “Break-even” point. Only at this price point am I at a position of no profit – no loss.
American Option Vs. European Option
An American option is an option that can be exercised anytime during its life. American options allow option holders (Option Buyer) to exercise the option at any time prior to and including its maturity date, thus increasing the value of the option to the holder relative to European options, which can only be exercised on the maturity date.