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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
For the owner of a call option with a $50 strike price, then the payoff at expiration ... we're talking about the value of that position. If the stock is below $50 we wouldn't exercise it, because we can buy it for cheaper than the option that the call option is giving us. If the stock goes above $50 we would exercise our option to buy at $50. Say the stock is at $60 the underline stock is at $60 on that date at the expiration date, then we would exercise our option to buy at $50 and sell at $60 and make $10. We would essentially get this upside above $50 on the stock. If we think about ... this is the actual value of the position, if we want to factor in how much we paid for the option, we would shift this down by $10. As the holder we would pay $10 for that. It would look this this. We would essentially ... if we don't exercise the option we loose the amount of money that was a loss that we have to pay for the option. Then above that we break even at $60 dollars, and then we make money above that. At $60 the value of our option is $10, but we paid $10 for it. That's our break even, but then we make money after that. This is from the perspective of the holder. This is from the perspective of the holder of the call option. This is the holder of the call option. What would it look like if you're the writer of the call option? If your the person selling the right to buy the stock. If this person right over here, if the holder has the right to buy at $50, someone must be selling them that right. Someone must be agreeing to say hey I will essentially sell that to you at that price. If you're the writer of the foot ... we have the holder in green. The holder in green. What if you're the writer? You're essentially the counter party on that option. You're the person agreeing to uphold that option. If the option never gets exercised, then the writer doesn't have to loose any money. If the option does get exercise, then all of a sudden, the writer starts to loose money. If the writer doesn't own the stock, and let's say the stock is at $60, this guy, the holder, can exercise his option to buy at $50. The writer would then have to go buy the stock on the market for $60 and sell it for $50. They would loose $10. The writers payoff would look something like this. Once again it's the mirror image of the payoff of the holder. If you think about the profit of the writer, if the option is never exercised, then the holder gets to keep the $10 that they were paid ... that they sold the right for. If the option is exercised, and they start to loose money, and their break even once again is at $60. Anything below that, then they start to loose more and more money. Once again these are the mirror images of each other. If you were to add up these two line it would be break even. These parties are the ones who are exchanging money between. If this guys makes $10 this guys loosing $10 or vice versa.