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Current time:0:00Total duration:3:33

Video transcript

let's say you think very highly if company ABCD and you're convinced that the stock price will go up from its current trading price of $50 per share its current trading price of $50 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 five dollars you could buy the option to buy this stock over the next month it expires in one month usually will be a specific date but I'm just saying a 1 month from the date that you buy the option and it gives you the option to buy the stock for $60 a share and 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 the to exercise the option to actually buy the stock anytime from the time you have the option until the expiration on a European option you only have the option you can 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 that 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 at 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 it 50 and then over here right at the top you're just a perfect market caller you are 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 you will have a profit of $30 now let's think about if instead of buying the stock you 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 could immediately sell it for $80 a share so you can make 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 five so you have a 15 15 dollar 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 that you had to put $50 of capital at risk to buy the option you only have 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 let's say the stock just completely plummets after you buy it 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 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 you'll only lose your $5