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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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# Call option as leverage

Video transcript

If we were to buy the stock for $50, so, this is the situation
where we're buying the stock, we're clearly
putting $50 up front. If the stock moved up
to $80, and we able to perfectly call the top
and sell it for that $80, we would make a $30 profit
off of a $50 initial investment. That's a 60%
gain. That's a 60% gain on our upfront capital. On the other side, if the stock were to go
down to $20, we would loose $30 of our $50
upfront investment. It would be a 60% loss. So in the
buying the stock based on the scenario that I
painted we could gain 60% or we could lose 60%. In
terms of the potential upside you can gain an unlimited amount. The stock can just really
go to any possible value. In terms of loss when
you buy a stock the most you can lose is 100%. Let's think about the
scenario with the call option. With the call option.
To buy the call option it only cost us $5. We only
have to put $5 upfront. The scenario where the
stock went up to $80, we figured out that we
were able to profit $15 net of the price of the
options. This was our pure profit. On a base
of $5 investment we were able to get $15 of profit.
We were able to get a 300% gain. We were
able to get a 300% gain. On the other side though
if the stock went down we had no reason to actually
exercise our option. We essentially just
lost all of the money of the option. We lost 100%. What I want to show here
is that when an option did is it gave us leverage.
It gave us leverage. The term comes from
physics, because a lever will give you kind of mechanical leverage. It can allow you to
exert more force than you otherwise could by using that simple tool. A call option is giving
you financial leverage. You're essentially making
this same bet here, but you're multiplying
potential gain or your potential loss. If the
stock you ... based on the scenario we painted
in the good scenario you made 60%. But in the
call option in the good scenario you made 300%. We multiplied. We multiplied our gain.
On the downside with the stock we lost 60%.
With the call option we lost 100%. Once again,
we multiplied our loss. Right here it looks the
numbers are still favorable, because our loss
multiplication wasn't as much as our gain multiplication. This is really based
on some of the numbers I chose. The important
thing to realize is if you're dealing with
option to essentially make the same bet, that the
bet that the company will go up, you're just
putting leverage on your bet. You're multiplying
your potential gains or losses.