Getting Started in Options by Michael C. Thomsett

Author:Michael C. Thomsett
Language: eng
Format: epub, pdf
ISBN: 9781118399316
Publisher: Wiley
Published: 2013-02-11T16:00:00+00:00

downside protection

A strategy involving the purchase of one put for every 100 shares of the underlying stock that you own. This insures you against losses to some degree. For every in-the-money point the stock falls, the put will increase in value by one point. Before exercise, you may sell the put and take a profit, offsetting stock losses, or exercise the put and sell the shares at the striking price.

The married put in this application provides you with downside protection, which reduces potential profits because you have to pay a premium to buy the insurance. If you intend to own shares of stock for the long term, puts will have to be replaced upon expiration, so that the cost is repetitive. However, as a long-term investor, you are not normally concerned with short-term price change, so the strategy is best employed only when you believe your shares currently are overpriced, given the rate of price change and current market conditions. In this situation, using puts for insurance is speculative but may remain a prudent choice.

In the event the stock’s market price rises, your potential losses are frozen at the level of the put’s premium and no more. This occurs because as intrinsic value in the put declines, it is offset by a rise in the stock’s market value. Whether you end up selling the put or exercising, downside protection establishes an acceptable level of loss in the form of insurance, and fixes that loss at the striking price of the put, at least for the duration of the put’s life. This strategy is appropriate even when, as a long-term investor, you expect instability in the market in the short term.

A summary of the insurance strategy is shown in Figure 4.5. Note that regardless of the severity of decline in the stock’s market value, the loss can never exceed 4.8 percent of the total amount invested (the cost of the put). That is because for every point of decline in the stock’s market value, the put increases one point in intrinsic value. This status continues until the put expires.

Figure 4.5 Downside Protection: Buying Shares and Buying Puts

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.