Strategies

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Protective Puts

 

ZYX shares purchased at $52 - ZYX put purchased at the same time

This investor decides to buy a protective put at the same time 100 shares of underlying are purchased at $52, and feels the need for insurance on this stock over a 3-month timeframe. There are no unrealized profits to protect, but downside price protection for the shares is provided none-the-less. Profit potential on the upside remains unlimited as ZYX shares increase in price. Available 3-month out-of-the-money ZYX puts are a $50 put trading for $1.90 and a $45 put trading for $0.50.

ZYX 50 Put Purchased

If the investor buys 1 ZYX 50 put for $1.90 then the 100 shares bought at $52 are protected below the strike of $50 per share, no matter how low the stock price declines - effectively a $2 deductible for the insurance provided. The downside maximum loss for this position is: $52 stock purchase price - $50 strike price plus the $1.90 put premium paid = $3.90, or $390 total. If the price of ZYX stock is below the strike at expiration the investor could exercise the put and sell the 100 underlying shares. The net sale price would be: $50 strike price - $1.90 cost of the put = $48.10, or $4,810 total. In this case the maximum loss would be realized: $5,200 net stock purchase price - $4,810 net stock sale price = $390. The investor would then have no position in ZYX stock or option.

If at expiration the investor feels that ZYX will not decline further then he could sell the expiring in-the-money put, which should have some market value, and retain the 100 shares for possible profit in the future. By doing this he could recoup some of the cost of the original put protection, and any profit realized from the put's sale could at least partially offset an unrealized loss seen on the shares at that point.

On the upside the break-even point on the shares is a ZYX price of: $52 stock purchase price + $1.90 put insurance premium paid = $53.90. In other words, the price of ZYX shares would need to advance above their purchase price by the amount of the premium initially paid for the put. Above that point, the net profit received from selling the 100 shares will be less the $190 put premium paid.

ZYX 45 Put Purchased

This investor could have instead purchased the more out-of-the-money ZYX 45 put to insure his shares purchased at $52. The result is a larger deductible of $7 ($52 stock cost - $45 strike), which means the shares are only protected below $45. The potential downside loss would be greater: $52 stock purchase price - $45 strike price plus the $0.50 put premium paid = $7.50, or $750 total. On the other hand, the upside break-even point would be lower: $52 stock purchase price + $0.50 put insurance premium paid = $52.50. The trade-off for this lower priced insurance policy is therefore less downside protection for a lower upside break-even point.


 
 

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