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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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# Put as insurance

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.