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Video transcript
Let's say that company ABCD is some type of a pharmaceutical company that has a drug trial coming out. And you're convinced-- it's right now trading at $50 a share-- but you're convinced that if the drug gets approved, that the company's stock is going to skyrocket. And you're also convinced that if the drug gets rejected, that the stock price is going to tank to maybe $5 or $10. So if you wanted to make money off of that belief, and I'm not necessarily recommending that you do. It's always trickier in reality than it sounds on paper. But one way that you could is you could actually buy both the call option and the put option on that stock. The put option is going to make you money if the stock tanks. And then the call option is going to make money if the drug gets approved and the stock skyrockets. So let's actually draw the payoff diagram here. So if the stock goes down, let's say it goes down to 0, you would exercise the put option. Because you could buy the stock for zero, exercise your put option, and sell it for $50. This is the right to sell the stock for $50. And of course, we're talking about the value of the combination now at expiration. So the stock is worth zero at expiration, the value of the put option is worth $50. The call option is clearly worthless. You wouldn't exercise the call option if the stock is worth zero. You would want to buy something for $50 that's worth 0. So from the stock's being worth zero, all the way up to the stock being worth $50, you would want to exercise the put option. But the value of the put option is going to become lower and lower and lower. And anything above $50, you wouldn't exercise the put option at all. But if you get above $50, you would want to exercise your call option. If the stock is worth $60 at expiration, then your call option is worth $10. Because you have the right to buy something for $50, which you can sell for $60. So then you have the value of your call option going up. So you can see a situation here. When you just think about the value of this bundle of the call plus the put option. That it's not much value if value of the stock doesn't change from $50, your options are worthless. But if you have a major movement, either to the upside or the downside, then this straddle, it's called. Let me write that down. When you go long a call and you go along a put, this is call a long straddle. In a long straddle you benefit from a major price movement. And when you think about it from the profit and loss point of view, you just shift it down based on the amount you paid for the two options. So in this case, we paid $20 for both options. So in this situation where we would exercise the put, instead of making $50, we have to net it for the $20 we paid for the options. So we would only make $30. And at the point where we're not exercising either option, because they're both essentially worthless, no reason to exercise them, then we essentially have just lost $20 for both options. So we will be down over here. And then anything above $50, will start to make money. So let me draw the option diagram over here. It will look like this, the payoff diagram It will look just like that. So when you actually factor in how much you paid for the options, you now see that you only would make money with this straddle if the underlying stock price, maybe after the results of the trial are released, hopefully get released before the maturity of the actual options. If the stock goes below $30, or if the stock goes above $70. But if it has one of those major movements, then this position, this straddle, this long straddle will make you money.