If we want to get the upside of owning a stock

while still mitigating the downside in case the stock price goes down

We saw that we could buy a stock and an appropriate put option

so that when the stock goes below some price

the put option starts to have value and so it mitigates our downside

And just as a review, these payoff diagrams are the values of, or at least the one on the left,

is the value of holdings at some future date

and we are defining that date to be the maturity date of the options under question

Now, and this one over here is the profit at that maturity date

and that's why we are subtracting the actual costs to enter the position on this one on the right

Now the question I want to answer in this video is, "How can we get the same payoff diagram without buying either stocks or puts?"

and as a bit of a clue, think about what happens if we were to just buy a call option

actually let me do it in that same color

So if you were to just have a call option, the payoff diagram would look like this.

You would never exercise the call option at expiration

unless, and we're assuming this is at expiration or at maturity,

but if the stock price goes above $50, you would then exercise your option to buy it at $50

So then it starts to have value as the stock price goes above $50

If the stock price goes to $60, you would exercise your option to buy at $50 and then you could sell at $60

and you would make $10

So you start to get some of the upside

So how can we shift this graph up to get exactly the same payoff diagram?

Well, we could have a call option and we could own something that would essentially shift this entire graph up by $50

So we could have, essentially, a $50 bond, or a bond that is worth, let me write it this way, a bond that is worth $50 at option expiration

So if there's some interest we're getting, we might be able to buy it for a little bit less

If there's zero interest, then it's pretty much like cash and we would pay $50 for it

But the payoff diagram for a bond that will be worth $50 at this date, at maturity, or at expiration

The payoff diagram for just the bond would look like this. It would just a straight line.

It's guaranteed to pay you $50

So if you own the bond and the call option, below $50 the call option is worthless, so you're just going to have the bond over here

And then, above $50, you still have the bond, but now the call option is worth something

So you have the value of the bond plus the call option

So at $60, the call option is worth $10. The bond is worth $50. The combination is worth $60

And so the combination of the call option plus the bond, you see it here on the left,

it's actually going to have the same payoff diagram as the stock plus the put

So you have the situation here that the stock plus an appropriately priced put

or a put with the appropriate strike price is going to be the same thing

when it comes to payoff at a future date, at expiration, as a bond plus a call option

And this right here is called "Put-Call Parity"

and it shows the relationship between all of these different securities

and if any of these prices start to, kind of, not make this thing hold true, there might be an arbitrage opportunity, but we'll cover that in future videos.

let's say that company abcd is some type of pharmaceutical company

that has a drug trial coming out

and you're convinced that

it's trading at 50 dollars 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 the company

if the drug gets rejected that the stock price

is going to tank to maybe 5 or 10 dollars

so if you want to make money

off of that beleif

and I'm not necessarily reccommending

that you do it

it's always tricker in reality than it sounds on paper

but one way that you could would be to buy 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 skyrockets

so let's actually draw the payoff diagram

so if the stock goes down

if the stock goes down

let's say it goes down to zero

you sould exercise the put option

you could buy the stock for 0,

excercise the put option

and sell it for 50 dollars

this is the right to sell the stock for 50 dollars

and of course we're talking about the value of the combination at expiration

so if the stock is worth zero at experation

then the put is worth 50

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 dollars that's worth zero

so from the stock 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

if you get above 50, you would want to exercise your call option

if the stock is worth 60 dollars at expiration, then your call option is worth 10 dollars

because you have the right to buy something at 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 think about the value

of this bundle of the call plus the put option

that it's not much value if the value of the stock doesn't change

from 50, your options are worthless

but you have a major movement

either to the upside or the downside,

then this straddle it's called

when you buy, when you go

long a call and long a put

this is called a long straddle

you benefit from a major price movement

when you think about it from the profit or loss point of view

you just shift it down from the

amount that you paid for the two options

in this case we paid 20 dollars for both options

so in this case where we exercise the put

instead of making 50 dollars

we have to net it for the 20 dollars we paid for the options

so we would only make 30 dollars

and at the point where we're not exercising either option

because they're both essentially worthless

there's no reason to exercise them

then essentially we have just lost 20 dollars

for both options so we will be down over here

and then anything above 50 dollars 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 this

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

myabe after the results of the trial

hopefully they get released before the maturity of the options

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