Lesson 2: With put options, if the stock price goes below the option's strike price, you can make a lot of money. If it doesn't, you lose your entire investment.

Let's say:

A stock is currently is trading at $100.00. You think that, over the coming year, the stock price is going to tank. You would like to make money if it does.

You buy a put option on the stock.

The option expires in one year (252 trading days from now).

The option has a strike price of $80.00.

The option costs you $2.56.

If the stock does tank, what kind of payoff might you get from the option?

What return might you earn on your investment of $2.56?

To find out, let's run a simulation.

(If you haven't already, to open the simulator, click the link at top right of this page. To jump quickly back and forth between the lesson and the simulator, hold down the Alt key on your keyboard and tap the Tab key.)

Type 2 in the Run Lesson Number box. Click Run Lesson Number.

In the simulator, the horizontal yellow line represents the option's strike price at $80.00. To get a payoff from the option, the stock price has to finish below the yellow line.

The distance from the yellow line to the green line represents what you paid for the option: $2.56. To make a profit on the option, the stock price has to finish below the green line.

For example, if, at the time of the option's expiration, the stock price is $55.63, then

Your profit is equal to the payoff minus the cost of the option:

On the investment in our example, we have a continuously compounded rate of return of 225.32% which is equal to a holding period return of 851.83%.

To simulate other payoffs you might get from this put option, click the button Simulate Price Change.

To continue to the next lesson, click arrow at top right of this page or...

Go deeper with the book

Option Pricing: Black- Scholes Made Easy
or with author and developer Jerry Marlow

Home

jerrymarlow@jerrymarlow.com
(917) 817-8659
www.jerrymarlow.com