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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Let's say you think very highly of Company ABCD, and you're convinced that the stock price will go up from its current trading price of $50 per share. You could do two things. You could either just buy the stock for $50, and hope that the price goes up. Or-- and I made this price up-- you could go to an options exchange and for the price of $5, you could buy the option to buy this stock over the next month. It expires in one month. Usually it will be a specific date, but I'm just saying one month from the date that you buy the option. And it gives you the option to buy the stock for $60 a share. The type of option that I've just described is called an American option. And it can be compared to a European option. An American option allows you to exercise the option-- to actually buy the stock-- any time from the time you have the option until the expiration. On a European option, you only have the option-- you could only exercise it-- on the expiration. But we'll just focus on the American. Now let's think about the different outcomes depending on what the stock does. So let's say the stock actually does do what you think it does. Let's say it goes up, and then it goes down. Let's say that you're really good at calling stock price tops. And then right over here-- let's take the two scenarios. Let's take the scenario where you bought the stock, and then you sell the stock. So you bought at $50 and then over here right at the top-- you're just a perfect market caller-- you were able to sell the stock at $80. So let's just think about the different profit scenarios. So here we have an end price of $80 per share. If you had bought the stock for $50, and now sold it at $80, you will have a profit of $30. Now let's think about if instead of buying the stock, you bought the option today. So if you bought the option, same thing. When the stock goes up to here, you'll say, oh, I think that's the top for the stock. Let me exercise my option. So I'm going to exercise my option, which gives me the right to buy the stock at $60 a share. So you're going to buy it at $60 a share, right over here. And then you can immediately sell it for $80 a share. So you can make $20 on that transaction. But of course, you paid $5 for the option itself. So you make $20 on the difference between 80 and 60, but you had to pay 5. So you have a $15 profit. So there it says, hey, look. Maybe I was better off buying the stock. And even there I would say, look, to buy the stock, you had to put $50 of capital at risk. To buy the option, you only had to put $5 of capital at risk. And to see that, imagine the negative scenario, where instead of the stock doing that, let's say the stock just completely plummets after you buy it. And it goes all the way down to $20. Now in the situation with the stock-- let's say right over there you just had enough. You just say, I want to sell the stock. So this is an end price of $20. In that situation, you bought for $50, sell for $20. You will lose $30. But in the option scenario, this entire time that it was plummeting, you'll say, I just won't exercise the option. The option is out of the money. It makes no sense for me to exercise it. So you just won't exercise the option. So you'll only lose the price that you paid for the option. You'll only lose your $5.