ZYX shares increase from $52 to $67 - ZYX put is purchased
In this case the investor has unrealized ZYX stock profits of: $67 current price - $52 purchase price = $15 per share, or $1,500 total. Protection of these profits is wanted for the next several months, so the investor considers the purchase of a three-month ZYX put contract. However, in the marketplace the investor currently has a choice between buying a ZYX 65 put for $2.70 and a ZYX 60 put for $1.10. Either would offer insurance on profits, but to different degrees, by guaranteeing a stock sale price no matter how low ZYX actually declines.
ZYX 65 Put Purchased
If the ZYX 65 put is purchased the net cost would be $2.70 x 100, or $270 total. If ZYX declines in price below the $65 strike price and the put is exercised at expiration, the 100 underlying shares would be sold at the strike of $65 per share. In this case the realized net profit on the stock purchase would be: $65 strike price - $52 stock's initial purchase price = $13 per share, or $1,300 total, less the $270 cost of the put. As insurance in the form of a $65 put was purchased when the underlying stock price was currently $67, the difference of $2 ($67 current stock price - $65 strike price) per share is given up because of the decline in ZYX stock price. This $2, or $200 total for 100 shares, could be considered the deductible for this insurance policy. The result: a premium of $270 was spent to protect $1,300 of the $1,500 profit unrealized when the put was purchased.
ZYX 60 Put Purchased
Let's now compare the purchase of a ZYX 60 put for $1.10 when ZYX stock is currently trading at $67. The total premium paid would be $1.10 x 100, or $110 total. If ZYX declines below the $60 strike price and this put is exercised at expiration, the 100 ZYX shares would be sold at the $60 strike per share. The realized net profit on the stock purchase would be: $60 strike price - $52 stock's initial purchase price = $8 per share, or $800, less the initial $110 cost of the put. As a 60 put was purchased when the underlying stock price was currently trading for $67, the difference of $7 ($67 current stock price - $60 strike price) per share is given up because of the stock price decline. The deductible on this insurance policy is therefore $7 per share, or $700 total. In this case a premium of $110 was spent to protect $800 of the $1,500 profit unrealized when the put was purchased.
In either scenario above, if at any point before expiration the investor decides that further downside protection for his stock is not needed the put may be sold, if it has market value, and possibly at a profit. In this case the shares would be retained. While owning the put the investor's upside potential profit remains theoretically unlimited as the stock price continues to increase. However, the cost of the put premium in effect increases the net stock purchase price by the premium amount paid. In other words, if the ZYX shares increase in price after the put purchase, and the put expires out-of-the-money and worthless, when the shares are eventually sold the realized profit over their purchase price will be less the put premium paid for insurance.