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Video transcript
Let's think about the pay off diagram for just owning the stock or we can say "going long the stock", which is really just owning it. If we think about just the underlying asset value and we're talking about the value at some date and, you know, and traditionally we're talking about some maturity date for some options, but the value at maturity but at some date we have in our mind. So if we're thinking about just the value, if on that date the underlying stock price is 50, then the value of holding the stock is going to be 50. If the value of the underlying stock is 0, then the value of owning stock is going to be 0. If the value of the underlying stock is 70, then the value of the stock is going to be 70. So you just have this very simple line payoff diagram. It's just whatever the underlying stock price, that is the value of the asset because you just own the stock. If you think about it from a profit and loss point of view, you break even if on that day since you're paying $50 per share for it today, if on whatever day we're talking about, the stock price at some future date, at maturity for some ... for some type of option. You paid 50. If the value is 50, then you're at break even. If the value is at 0, then you just lost $50. So you're going to be at -50 over here. If the value of the stock price on that day goes to 60, 70, 80, 90, 100, then you just made $50. So it's going to be this point right up here. Your profit will be 50. So you see, a payoff diagram that looks something like this. And once again, the only difference between this payoff diagram and that payoff diagram is that this one right here is shifted down by $50 to incorporate the price that you paid for it. Now, let's say this is what happens if you just buy the stock and let's say you want to buy the stock and let's say, you want to buy the stock, but you want to mitigate your downside risk. You want to buy some insurance on your stock. You want to mitigate the downside. So what you can do is, you can literally just also buy a put option, maybe with a strike price right at $50. You want to mitigate your downside if the stock goes below 50 and if you do that and I'll only do it on this payoff diagram, you could just shift it down for this one. What would it look like? Well, just the put options payoff diagram looks like this. We've already drawn. Let me try to do that in the color of the put option. We've already done that in a previous video. It looks something like this. If the underlying stock price is 0, then the put option is worth 50 because you can buy it for 0 ... Buy the stock for 0 and then you have the right to sell it for 50 and then the value of the put option is worthless if the stock can actually be sold for 50, then you wouldn't exercise the put option. But what happens if you own both? If you own both at maybe the maturity of the option, if the stock is worth 0, your stock part is worth 0 but the option is worth 50, so the combination is going to be worth 50. If the stock is worth 25 ... If the stock is worth 25, then the put option is also worth 25. So if you own both of them, the combination is going to be worth 50. If the stock is worth 50, the put option is worth 0. You own the combination is going to be worth 50. Anything above 50, the put option is just worth 0 but then you have the value of the stock. So the stock + the put would look like this payoff diagram, would just look like this payoff diagram right over here. So when you look at this, what happened is we'll get all of the upside if the stock goes above 50, but we've mitigated our downside. This is ... This right here is the stock + the put option. And what you see here is the put is acting as insurance. When people talk about buying insurance on a position, they're usually talking about buying a put option. And of course if we were to draw the same graph over here we would shift it down by the amount you pay for the stock and for the $10 that you're paying for the put option. So, you would shift this graph down by $60 because that's what it pays ... what it costs to go into this position.