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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 that you don't like company ABCD that's right now trading for $50 a share. But you don't have the stomach to short the stock because there's a possibility that you could lose an infinite amount of money if you short it. You still have an option. Quite literally, you still have an option. You can buy a put option. Once again, we're dealing with the American variation. And just like an American call option, an American put option gives you the right to exercise the option any time before the expiration date. A European call or put option, you can only exercise on the expiration date. And the situation with a put option, a call option gave you the right to buy the stock at a specified price. A put option is the opposite. It gives you the right to sell the stock at a specified price. So this little made up put option I've constructed right here. It's maybe being sold on an exchange for $5 per option. And it gives you the right to sell company ABCD at $40 a share any time over the next month. And let's see how, if you were to buy this, how this really is a bet that the company would go down. So let's imagine the scenario where the company does what you expect, it goes down. And one month later, it just keeps going down. You're like, well, I better use it today because it's going to expire if I don't use it today. So you exercise the option right over there. And so what this allows you to do is sell the stock at $40. And if you don't own it, that's OK because you could go and buy the stock right now on the market. You knew it was going to get cheaper. So you can buy it for $20, and then exercise your option and sell it for $40. So you're buying at $20 and immediately selling for $40. So you're going to be making $20. And then if you subtract out the price that you had to pay for the option, you're going to have a $15 profit. You're going to have a $15 profit over here. Let me scroll over to the right so you have some space. And this is, of course, the situation with the put option. This is the put option. And if your bet goes against you and the stock actually goes up, it's not going to be like a short position where you can lose an unlimited amount of money. In that situation, let's say the stock just keeps going up and up and up and up. Well at any point above $40, you're like, there's no point in me exercising the option. So you just let it expire. So in that situation, you just wasted your money buying the actual option. So you just lose the actual $5. Even if that stock were to go up to a gazillion dollars, you're not required to buy it back like you would if you were shorting it. You can just let the option expire.