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## Finance and capital markets

### Course: Finance and capital markets > Unit 9

Lesson 1: Put and call options- American call options
- Basic shorting
- American put options
- Call option as leverage
- Put vs. short and leverage
- Call payoff diagram
- Put payoff diagram
- Put as insurance
- Put-call parity
- Long straddle
- Put writer payoff diagrams
- Call writer payoff diagram
- Arbitrage basics
- Put-call parity arbitrage I
- Put-call parity arbitrage II
- Put-call parity clarification
- Actual option quotes
- Option expiration and price

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# Put as insurance

Put as Insurance. Created by Sal Khan.

## Want to join the conversation?

- Taking the S+P curve on the left (blue) and shifting it down by 60$ (As 50$ for your capital, and 10$ for your put) wouldn't you end up with the same P/L graph (right) as doing a call option?

What are the advantages of doing a S+P, when a call would yeild the same results?(19 votes)- In this scenario you already own the stock. Reasons for ownership may be you bought early with the intent to go long in the far past or you had the stock to capitalize on the dividends. If you are day trading than a call would work but if your portfolio has stocks that you have had for a while but you feel the need to change your positions in the near future based on some hunch in the market or life event where you may need cash out than a PUT would be good insurance in the short term until that date.(10 votes)

- If I buy a call option and a put option of the same stock at the same strike price for about $10.00 each, would it be as if I have mitigated my risk completely whereby I would profit from the transaction regardless of which way the stock moves provided that the stock changes its value by $10.00 or more? Furthermore, what happens if the stock moves up or down in the above case and I sell the call or put option itself depending on which way the stock moves instead of exercising the option?(6 votes)
- To answer your first question; to benefit from owning a call and put ($10/option) on the same stock it must vary more than $20 either way to cover the costs of buying the two options.

Secondly; If there is a huge movement in price then yes the time value of the option may be more than the value if exercised. This time value diminishes towards expiration date. Most people say that a call option must never be exercised early as the time value is generally more valuable than the exercise value, as the market perceives further bullish behaviour. This is why European options are generally better.(13 votes)

- Correct me if I'm wrong, but the graph on the left should have the value shifted downwards by $10 since it should incorporate the price of the actual option.(2 votes)
- The graph on the left only shows the value of the stock and the put, it doesn't include cost. The cost would be included in the P/L on the right, but Sal doesn't finish that graph.(9 votes)

- Does the put option work as insurence also for bond holders?(2 votes)
- There are put options on bond futures that work very similar to put options on stocks. But those are the only exchange traded options on bonds.

There are put options on individual bonds, but they work differently than stock options. They are not exchange traded, rather they are part of the bond. An issuer may issue bonds that have an embedded put option, which gives the bond holder the right to sell the bond at a certain price in the future. This helps bond holders protect themselves against rising interest rates and allows the bond issuer to issue bonds at a lower interest rate.

Not every bond issued has an embedded put option. There are also embedded call options that exist, as well as many other provisions that can exist within a bond.(6 votes)

- I know in these examples to buy an option has been about $5 or $10... what about in the real world? Is it much more than this or just relative to the stock you are buying?(2 votes)
- you purchase 100 shares of stock at $44 per share and wish to hedge

your position by writing a 100-share call option on your holdings. The option

has a 40 strike price and a premium of 8.50. If the stock is selling at 38 at the

time of expiration, what will be the overall dollar gain or loss on this covered

option play? (Consider the change in stock value as well as the

gain or loss on the option.)

what would be gain or loss if the stock ends up at $41, 25, 57, or 70(1 vote)- Please confirm this is correct...

Two aspect to the p/l, share price and option premium (income).

Right away $8.50 in option premium was earned, times 100 shares equals $850 cash received.

Then we evaluate the stock price movement for that part of the p/l and whether it brings down the option premium earned. For example, if the stock MV is $38 at expiration, the holder of the call option will not exercise as they can buy the shares in the open market at a lower cost.

Therefore, for the writer of the call option, there will be income of $850 (premium received) but that premium income will be reduced by the decline in MV to $38, which is a loss per share of $6, then multiplied by 100 shares, is a $600 loss.

Net net, the writer of the call option will have a $250 gain (850-600) on the covered option play.

@38 +$250 [(100*(38-44)+(100*8.50)] option worthless, equity loss + option premium

@41 +$550 [(100*41-44)+(100+8.50)] breakeven $48.50 --> option worthless, eq. loss + opt premium

@25 -$850 [(100*(25-44))+(100*8.50)] option worthless, equity loss + option premium

@57 +$450 [(100*(40-44))+(100*8.50)] bought at 44 and sold at 40(2 votes)

- Hi can anyone explain to me how the equity (of a firm with debt in its capital structure) is considered a call option? thank you(1 vote)
- It is a call option on the assets of the firm, because if the company turns out to be very valuable (i.e. the option is in the money), the equity holders just pay off the debt holders (exercise the option) and they have ownership of all the assets. But if the company turns out to have less value than the debt, the equity holders can walk away, theor option expires "unexercised", and the loss to the equity holders is limited to what they originally paid for the stock / option.(2 votes)

- If at expiration the option the stock went from 50 to 25 you will not lose because the option is worth 25 and the stock is worth 25 so you have that value my question is why would a trader do this if they can't make a profit on the transaction?(1 vote)
- I am so confused. I watched this video three times but didn't get anything. Please can anyone help me?(1 vote)
- Shouldn't we consider Margin/ premium of put option here?

I guess above transaction will be profitable only after stock price rises above original stock price plus the margin value.

In above diagram profit curve should shift right by margin call, to offset put expiration. Whats you say, Sal?(1 vote)

## 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.