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Current time:0:00Total duration:3:53

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 this year 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 companies if the drug gets rejected that the the stock price is going to tank to maybe five or ten dollars 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 stock becomes if the drug gets approved and the stock skyrocket so let's just actually draw the payoff diagram here so if the stock goes down if the stock goes down just let's say it goes down to zero 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 of the combination now at expiration at expiration so if the stock is worth zero at expiration the value of the put option is worth fifty the call option is clearly worthless you wouldn't exercise the call option if the stock is worth zero you wouldn't want to buy something for $50 that's worth a zero so from from the stock of being worth zero all the way up to the stock being worth fifty you would want to exercise 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 fifty you wouldn't exercise the put option at all but if you get above fifty you would want to exercise your call option if the stock is worth $60 at expiration then your call option is worth ten 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 the stock doesn't if the if the value of the stock doesn't change from 50 your your 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 buy when you go long as a call and you go long and put this is called a long straddle and a long trial you benefit from a major price movement and when you think about from the profit and loss point of view you just shift it down based on the amount that you paid for the two options so in this case we paid we paid $20 for both options so in this situation where we would exercise the foot 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 we're really they're both they're both essentially worthless we're not going to 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 anything above $50 will start to make money so let me draw the option diagram over here and look it will look like this it will look like this the payoff diagram it will look just 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 the results of the trial or at least hopefully they get released before the maturity of the actual options if the stock goes below if the stock goes in this area 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