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Current time:0:00Total duration:3:22

Video transcript

payoff diagrams or way of depicting what an option or set of options or options combined with other securities are worth at option expiration and what you do is you plot it based on the value of the underlying stock price and I have two different plots here one that you might see more in an academic setting or a textbook and one that you might see more if you look up payoff diagrams on the internet or people actually trading options but they're very similar this one just worries about the actual value of the options at expiration this worries about the profit and loss so this will incorporate what you paid for the option this will not this just says what it is worth so with that said we have company ABCD trading at $50 per share and then we have a call option with a $50 strike price or $50 exercise price trading at $10 which tells us that the owner of that option has the right but not the obligation to buy company ABCD stock at $50 per share up to expiration assuming it's an American option if it was a European option it would be on expiration so what is the value of this option at expiration so this is value at expiration at expiration so if the stock is worth less than $50 the owner wouldn't execute it they wouldn't they wouldn't exercise the option so the option would be worthless it would be worthless they would just let it expire no reason to actually exercise the option now if the underlying stock price is worth more than 50 if it's $51 then you would exercise it because it's now the option is worth $1 you can buy something for $50 and sell it for 51 so it's now worth $1 if the underlying stock price is $60 of course you would exercise and it's now worth $10 because you can buy something for 50 and you could immediately sell it at 60 we're saying that the underlying stock price is 60 so it would be worth 10 and so you have a payoff diagram that looks something like this it kind of hockey sticks below 50 it's worthless and then above 50 all of a sudden it becomes worth something now if you do it in the profit and loss model all you have to do is incorporate what you actually paid for the option so in this situation below $50 you still would not actually exercise your option because why would you pay $50 for something that's actually trading for less than $50 but you would say hey I would have had to take a $10 loss because I paid $10 for that option so up until $50 your profit is negative 10 you have lost $10 you have lost the price of the option because you wouldn't exercise it then all of a sudden if the stock price goes above $50 you would exercise it but you would still have a negative profit because you still haven't made up the price of the option all the way up until 60 at $60 or appreciation at $60 per share for the underlying stock price you could exercise the option buy the stock at 50 sell it at 60 you would make 10 dollars doing that but of course you have to spend $10 on the option so there you are breakeven but then as you get above a $60 stock price at maturity then all of a sudden you start to make money so these are both legitimate payoff diagrams for a call option for this call option right over here they're just different ways of viewing it this is the value of the option this incorporates the actual cost of it