As previously stated, when we buy a stock, three potential
outcomes exist. The stock can go up, go down, or remain
stagnant. Let's hypothesize results across these three
scenarios. Say you buy the stock for $31.00 and buy the front
month 30 put for $1.00.
In the "up" scenario, let's assume the stock price is $31.50 at
expiration. The results are that you have a $.50 gain from
capital appreciation and a $1.00 loss from the purchase of the
put which combined gives us a $.50 overall loss.
It is important to realize that the up scenario will only
produce a positive return if the stock gain is greater than the
amount paid for the put. That being the case, you calculate the
breakeven point for the protective put strategy by adding the
purchase price of the stock to the price of the put.
In the "up" scenario, add the stock price $31.00 plus the option
price $1.00 and you get a breakeven of $32.00. So, until the
stock reaches $32.00, the position will not produce a positive
return. Above $32.00 the position will gain the amount equal to
the stock price minus the premium paid for the option..
In the "stagnant" scenario, the position will produce a loss.
Since the stock hasn't moved, there will be no capital gain or
loss and with the stock at $31.00 at expiration, the puts are
worthless. The position lost $1.00, the amount you paid for the
puts.
In the "down" scenario, the position will again produce a loss.
If the stock price were to trade down $1.00 to $30.00, then you
would have a $1.00 capital loss.
With the stock at $30.00, the 30 puts will be worthless, thus
you incur a $1.00 loss because that is what you paid for them.
Your total loss will be $2.00.
However, in the "down" scenario, the protective put will set a
cap on your losses. Let's see how that works. We'll set the
stock price down to $28.00. Since you purchased the stock at
$31.00, there will be a capital loss of $3.00.
The puts, however, are now in the money with the stock below
$30.00. With the stock at $28.00, the 30 puts are worth $2.00.
You paid $1.00 for them so you have a $1.00 profit in the puts.
Combine the put profit ($1.00) with the capital loss (-$3.00)
and you have an overall loss of $2.00. The $2.00 loss is the
maximum amount you can lose regardless of how low the stock
declines, even if it goes as low as zero. This is what is meant
by maximum protection.
In every protective put position it is possible to calculate
your anticipated maximum loss. Use the formula: (stock price
minus strike price) minus the option's price equals total
maximum loss.
Maximum Loss = (Stock Price – Strike Price) – Option Price
For example, suppose you paid $30.00 for your stock. You bought
the front month 27.5 put for $1.00. Next, assume the stock
closes at $27.50 on expiration day.
Your maximum loss calculation would be:
($30.00 –$ 27.50) - $1.00 = $3.50
$30.00 (stock price) minus 27.5 (strike price) equals a $2.50
capital loss. Do not forget that with the stock at $27.50, the
27.5 puts will be worthless.
Add the capital loss ($2.50) plus the option loss ($1.00). The
total is $3.50 which is your maximum possible loss in that
position. This formula will work every time.
Looking at the three hypothesized scenarios, we find that only
one scenario, the "up" scenario, can produce a positive return
and that's only when the stock increases more than the amount
you paid for the puts.
The other two scenarios produced losses. If the stock is
stagnant, you lose the amount you paid for the put. If the stock
goes down, you lose again- but the loss is limited. It is the
limiting of loss that makes the protective put an attractive and
useful strategy.
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