Part 1 – The Protective Put
Options are a financial instrument that you can use for all types of market conditions, whether you’re hedging your stocks or looking to salvage a losing stock position.
Over the next weeks I’ll be covering a number of commonly used options trading strategies that you can execute without any margin requirement. Today we will look at the Protective Put.
Protective Put – it’s like buying insurance for your stock position
If you are of the view that a stock may start to recover but you still want some protection in case it continues to fall, you could use what is known as a “Protective Put” strategy in order to stop your position from making further losses. The Protective Put strategy simply involves buying 1 contract of put options for every 100 shares that you own, at a strike price below the level at which you do not want to own the stock.
The Protective Put options strategy not only protects your stock position if the price goes down further, it keeps the upside open so that if the stock turns around and rallies, you will not miss out on the move.
An example of a protective put situation would be News Corp. The stock is trading into resistance at the moment and if for some reason you did not want to sell your News Corp holdings, you could by a protective put.
If you bought the stock at $16.00, you could buy the Aug11 17.00 Put for $0.17.
This would protect your position down to $16.83 (= $17.00 -$0.17) thereby locking in profits on your position and protecting your downside risk at the same time.
This can be analysed using the Derivative Profiler option in the Market Analyser software.
The Market Analyser software allows you to modify the prices to reflect the current price and provides Profit & Loss diagrams for your strategy.
If you are more convinced that the News Corp share price is about to fall then you should simply sell the stock and buy the put outright for far more superior returns, while only risking the premium you paid for the put.
Options can be used to reduce your risk while participating in the profits from a significant move by the underlying stocks. The Protective Put is simply buying insurance for your stock position. In our next article we will talk about the Covered Calls for generating monthly “rental” income from your current stock position.
Utilise the features in Market Analyser to plan your options trades for the particular options strategy, using your specific trade selection criteria. You will save time and potentially reduce your trading risk.
By Michael Hevern
Head of Research
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