Option "payoff" vs profit

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markCFAIL

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Just solved a problem that gave me a put option strike and the current stock price, as well as the premium for the option. It asked for the payoff, which ignored the premium.
I am going to assume when they say “payoff” they mean strictly what you get paid excluding the premium, which was presumably paid up front and not part of “payoff”, but if they ask for “profit”, then you include the premium.
So stupid, how does this further our knowledge? This test is becoming more and more about “gotchas” than knowledge.
 
Payoff = Value of the Option. = Vt
Profit = Payoff - Initial Investment. = Vt - V0.
 
There is no ambiguity between payoff and profit. Think of a lottery you just won for $363 million . That is your payoff . If you bought 10 tickets to play at $1 each, your profit is ( $363 million - $ 10 ). No ambiguity.
 
Yeah, I agree that when you look at the two words side by side it is clear cut. I guess I just wasn’t looking for a question to diferrentiate the two since nobody in the real world gives a shit about payoff, it’s profits that matter. Who cares what you made without paying the premium?
 
The difference is you can come up with payoffs without knowing a price. There is obviously no way to calculate a profit with no associated price of an option, and good luck knowing that ahead of time “in the real world.”
 
Not sure I understand .
What do you mean by not knowing the price of the option ahead of time?
Call the dealer and they will tell you . What am I missing?
 
Its called the premium, its quoted and you have to pay it before you get the option, so …. i am a bit confused too aaron?
 
A call with a strike of 80 will always have a payoff of 10 if the stock is 90 at expiration, but the price of that call is unpredictable. You can’t determine a market price a priori.
I’m not referring to whatever problem you solved that told you the option price. I’m speaking generally. Payoffs and profits are only related by market forces, so it is often useful to consider them separately.
 
dude, you haven’t bought an option before have you?
 
Please tell me what the price of a July expiration call on Microsoft will be next week, dude.
 
You pay the premium up front, so you know your potential profits from the get-go, nobody cares about a raw payoff, thats just not really important in the non-academic world.
I think I get what you are saying though…. you are making the point that you always know the payoff, but if you have not already purchased an option and are still waiting for some reason (such as price to come to you I suppose), then the profit in the future position is unknown. I guess I see your point, but I don’t think anybody looks at options that way outside of the CFA curriculum.
 
I’m glad you get what I was trying to say. I agree that it’s an academic issue and not a practical one, but then I also think the CFA exams are very academic in nature. (Good) Finance is all about theory, and I can appreciate that it would be frustrating for someone in industry to have to keep track of what would appear to be trivial nuances. Luckily (?), I haven’t left academia yet so those things are fresh in my mind.
 
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