To Protect Falling Stock Price

ZYX shares decrease from $52 to $42 - ZYX put is purchased

This investor has seen a significant decline in unprotected stock value from $52 to $42, but does not want to sell the 100 shares. However, he is willing to commit a small amount of cash to this losing stock position for protection from further decline and decides to purchase a protective ZYX 40 put. In the marketplace a 1-month 40 put is trading for $0.50, a 2-month 40 put for $1.00, and a 3-month 40 put for $1.40. He decides that buying the 3-month put for a total premium of $140 suits his tolerance for further cash commitment, gives him the downside stock price protection he wants, and fits his timeframe for possible further decline.

This $140 insurance will protect the 100 shares previously bought for $52 below the guaranteed sale price of the $40 strike. The investor has already seen an unrealized loss of $1,000 from the significant stock price drop from $52 to $42. But no matter how much more ZYX declines in price, further downside loss is limited to: $42 current stock price - $40 strike price plus the $1.40 put premium paid = $3.40, or $340 total. In other words, by purchasing put protection the investor has stemmed a total loss on his original $5,200 stock investment to a maximum of $1,000 plus $340, or $1,340. The cost of the put, however, has resulted in a break-even point on the original stock purchase of: $52 stock purchase price + $1.40 put premium paid = $53.40 per share.

If at expiration ZYX has declined well below the put's $40 strike price the investor may exercise the put and sell the 100 shares for a net price of: $40 strike price - $1.40 cost of the put = $38.60, or $3,860 total. This would represent a net realized loss from the original $5,200 stock investment of the maximum $1,340. Alternatively, if the investor decides the shares no longer require downside protection at this point he could sell the put contract to recoup some if its original cost or possibly make a profit. In this case the shares would be retained. The investor would then be poised to recoup some or all of the original stock investment if the price of ZYX increases, or to possibly profit if its price rises high enough.

For investors finding themselves with a losing stock position in need of further downside protection there are strategies other than the protective put that might be considered. Among them is the "Stock Repair" strategy.


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