Let's say you think very highly of company ABCD,
and you're convinced that the stock price will go up
from its current trading price of $50 per share.
You could do two things:
you could either just buy the stock for $50
and hope that the price goes up,
or — and I made this price up —
you could go to an options exchange and,
for the price of $5,
you could buy the option to buy this stock
over the next month. It expires in one month.
Usually it'll be a specific date,
but I'm just saying,
one month from the date you buy the option,
and it gives you the option to buy the stock
for $60 a share.
And the type of option I've just described is called
an American option.
And it can be compared to a European option.
An American option allows you to exercise the option
— to actually buy the stock — any time
from the time you have the option
until the expiration.
On a European option, you only have the option,
you can only exercise it on the expiration.
But we'll just focus on the American.
Now let's think about the different outcomes
depending on what the stock does.
So let's say the stock actually does do what you think it does.
Let's say it goes up and then it goes down.
Let's say that you're really good at calling stock price tops.
And then right over here, let's take the two scenarios.
Let's take the scenario where you bought the stock
and then you sell the stock.
So you bought at $50, and then over here
right at the top, you're just a perfect market caller,
you're able to sell the stock at $80.
So let's just think about the different profit scenarios.
So here we have an end price of $80 per share.
If you had bought the stock for $50 and now sold it at $80,
you will have a profit of $30.
Now let's think about if, instead of buying the stock,
you bought the option today.
So if you bought the option,
same thing, when the stock goes up to here,
you'll say, "Oh, I think that's the top for the stock,
let me exercise my option.
So I'm going to exercise my option
which gives me the right to buy the stock at $60 a share."
So you're going to buy it at $60 a share,
right over here,
and you can immediately sell it for $80 a share.
So you could make $20 on that transaction,
but, of course, you paid $5 for the option itself.
So you make $20 on the difference between $80 and $60,
but you had to pay $5.
So you have a $15 profit.
So there it says, hey, look,
maybe I was better off buying the stock!
And even there I'd say, look,
to buy the stock you had to put $50 of capital at risk.
To buy the option, you only had to put $5 of capital at risk.
And to see that, imagine the negative scenario,
where instead of the stock doing that,
let's say the stock just completely plummets after you buy.
And it goes all the way down to $20.
Now in the situation with the stock,
let's say right over there you've just had enough.
You say, "I just want to sell the stock."
So this is an end price of $20.
In that situation, you bought for $50, sell for $20,
you will lose $30.
But in the option scenario, this entire time that it was plummeting,
you'll say, "I just won't exercise the option."
The option is "out of the money."
It makes no sense for me to exercise it.
So you just won't exercise the option.
So you'll only lose the price that you paid for the option.
You'll only lose your $5.
Let’s see you don’t like company A B C D very much and you convince that the stock is going to go down.
So, in that situation, you can actually short,
you can actually short the stock which in very high level is bet the stock is going to go down.
And the way you do that mechanically is that you borrow the stock.
You borrow the stock, from someone else who owns it.
And you immediately sells that stock that you don’t even know, you sell the stock borrow from someone else.
And you will sell at current price
So, for example,
at this situation, you’ll sell it, you’ll sell it at current trading pricea, of 50 dollars
You then hope that stock price goes down
So, in this situation, let’s think about this situation where the stock price goes down
So if you shorted it, right over here you borrow the stock and you sold it for 50 dollars
And then the stock actually go down. Iets go all the way down to 20, you think that’s about how far it’s gone go down
Then, you can buy back the stock
You can buy the stock, you can buy the stock for 20 dollars
In this situation, and then give it back to the owner you had borrowed the stock and now you can hand back the stock to the owner
So, you can give it back you’ve centrally unwanted it. What allow you to do is allow you to do the buying and selling in revise order
Normally, before you sell something you have to buy something
But here you are able to sell it and buy it later for a lower price so the situation were the end prices 20 dollars
You have sold it for 50, so that 50 dollars and you have to use 20 of it to buy it back
So in that situation, you’ve shortening the stock you would have made, you would have made 30 dollars
Let me wirte this columns here, this is shorting, this is the short option
You sold it 50, you borrowed and sold 50, then when it went down 20 you bought is back, you bought it back for 20
So you have 50 dollars processed, and you have used 20 of it to buy back ,so you have 30 dollars profits
but that’s only good scenario ,what happens if your band is wrong what happens, if the stock price goes up to 80 and over here
you get so scared like oh my god, I have to buy this stock back by 80, what if it’s keep going up, I will lose unlimited lots of money
So, over here, you get scared and you unwilled your situation. You say :OK, I’ll go and buy the stock for 80 dollars
So ,I can give it back, So, in this situation, stock goes up, you actually can loose a lot of money
You had sold for 50, so, you only have 50 dollars that you have from transaction, but now you have to buy the stock for 80
So if you sold for 50, and you’ll buy for 80. You now lost 30 dollars, 30 dollars in a whole
So, now, you are negative, negative 30 dollars, really shorting is the riskiest of all of things you can do
Because a stock price goes unbelievably high. What happens suppose stock goes 800 dollars, suppose 8000 dollars
All of a sudden, you’ve, you’ve sold something for 50 and you have the obligation it’s some point of future,
because you have to get the stock back of paying 500 dollars, 800 dollars, 8000 dollars you don’t know how much you’ve go to lose
So it’s the really the riskiest thing you can do , but it is one way to bet that stock price will go down or profit from the stock price going down.
Let's say that you dont' like company ABCD
that's right now trading for 50 dollars a share
but you don't have the stomach to short the stock
because there's a possibility that you could lose an infinite amount of money
if you short it
you still have an option
quite literally you still have an option
you can buy a put option
once again we're dealing with the American variation
and just like an American call option
an American put option gives you the right to exercise the option any time before the expiration date
a European call or put option you can only exercise on the expiration date
and the situation with the put option
a call option gave you the right to buy the stock at a specified price
a put option is the opposite
it gives you the right to sell the stock at a specified price
so this little made up put option I've constructed right here
is maybe being sold on an exchange for five dollars per option
and it gives you the right to sell company ABCD at 40 dollars a share
any time over the next month
and let's see how, if you were to buy this
how this really is a bet that the company would go down
so let's imagine the scenario where the company does what you expect
it goes down and one month later
it keeps going down
you're like, I better use it today, because it's going to expire
if I don't use it today
so you exercise the option right over there
and so what this allows you to do is sell the stock at 40 dollars
and if you don't own it, that's ok, because you can go and buy the stock
right now on the market
you knew it was going to get cheaper
so you can buy it for 20 dollars
and then exercise your option and sell it for 40
so you're buying at 20, and immediately selling for 40
so you're gonna be making 20 dollars
and then if you subtract out the price that you had to pay for the option
you're going to have a 15 dollar profit
you're going to have a 15 dollar profit over here
let me scroll over to the right so you have some space
and this is of course the situation with the put option
this is the put option
and if your bet goes against you
and the stock actually goes up
it's not gonna be like a short position where you can lose an unlimited amount of money
in that situation let's say the stock just keeps going up and up and up
well, any point above 40 dollars, it's like, you know
there's no point in me exercising the option
so you just let it expire
so in that situation you just wasted your money buying the actual option
so you just lose the actual 5 dollars
even that stock were to go up to a gazillion dollars
you're not required to buy it back like you would if you were shorting it
you can just let the option expire
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