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An investor who purchases a put option while holding shares of the underlying
stock from a previous purchase is employing a "protective put."
MARKET OPINION: Bullish on the underlying stock.
The investor employing the protective put strategy owns shares of underlying
stock from a previous purchase, and generally has unrealized profits accrued
from an increase in value of those shares. He might have concerns about
unknown, downside market risks in the near term and wants some protection
for the gains in share value. Purchasing puts while holding shares of
underlying stock is a directional strategy, but a bullish one.
Like the married put investor, the protective put investor retains all benefits
of continuing stock ownership (dividends, voting rights, etc.) during
the lifetime of the put contract, unless he sells his stock. At the same
time, the protective put serves to limit downside loss in unrealized gains
accrued since the underlying stock's purchase. No matter how much the
underlying stock decreases in value during the option's lifetime, the
put guarantees the investor the right to sell his shares at the put's
strike price until the option expires. If there is a sudden, significant
decrease in the market price of the underlying stock, a put owner has
the luxury of time to react. Alternatively, a previously entered stop
loss limit order on the purchased shares might be triggered at both a
time and a price unacceptable to the investor. The put contract has conveyed
to him a guaranteed selling price at the strike price, and control over
when he chooses to sell his stock.
Maximum Profit: Unlimited
Maximum Loss: Limited
Strike Price - Stock Purchase Price + Premium Paid
Upside Profit at Expiration:
Gains in Underlying Share Value Since Purchase - Premium Paid
Potential maximum profit for this strategy depends only on the potential price increase
of the underlying security; in theory it is unlimited. If the put expires in-the-money,
any gains realized from in an increase in its value will offset any decline in the unrealized
profits from the underlying shares. On the other hand, if the put expires at- or out-of-the-money
the investor will lose the entire premium paid for the put.
BEP:Stock Purchase Price + Premium Paid
Volatility Increases: Positive Effect
Volatility Decreases: Negative Effect
Any effect of volatility on the option's total premium is on the time value portion.
Passage of Time: Negative Effect
The time value portion of an option's premium, which the option holder has
"purchased" when paying for the option, generally decreases, or decays,
with the passage of time. This decrease accelerates as the option contract
approaches expiration. A market observer will notice that time
decay for puts occurs at a slightly slower rate than with calls.
The investor employing the protective put is free to sell his stock and/or
his long put at any time before it expires. For instance, if the investor
loses concern over a possible decline in market value of his hedged underlying
shares, the put option may be sold if it has market value remaining.
If the put option expires with no value, no action need be taken; the investor
will retain his shares. If the option closes in-the-money, the investor
can elect to exercise his right to sell the underlying shares at the put's
strike price. Alternatively, the investor may sell the put option, if
it has market value, before the market closes on the option's last trading
day. The premium received from the long option's sale will offset any
financial loss from a decline in underlying share value.
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