Investment Objectives of Protective Puts
Insurance: a term you're definitely familiar with if you own a car or home or rent an apartment. It's necessary to ensure that a financial catastrophe doesn't ruin your life. And when it comes to financial assets, a protective put option can provide "insurance" to the underlying's price decrease.
Think about a position you've taken in HawkTalk Inc. (HTTK) with 1,000 shares at EUR 10 per share.
In this case, you could buy a one-year put at EUR 8 strike for EUR 0.50. The EUR 0.50 represents the time value because the put option is not in the money.
EUR 2 is computed as the difference between the current price and the put strike. What does that represent?
Bingo!
That's not it.
The EUR 2 between the current price and strike represents a deductible, or the amount you'd lose before your put "insurance" kicks in. But you'd also need to factor in the cost of the put, or the premium paid.
The max loss for a protective put is
$$\displaystyle S_0 - X + p_0$$
where _S_0 is the stock price when the option position opened, _X_ is the exercise price, and _p_0 is the put premium paid or received.
A protective put breakeven has similar inputs as a covered call option, except the put premium is paid instead of received like a call.
Since the two option strategies have similar inputs, buying a lower strike put option will have the same impact of selling a covered call for a higher strike price. How would that impact the premium versus an at-the-money put?
No.
The strike impacts the time value of the out-of-the-money put option.
Not quite.
The probability of the put being in the money is lower for a smaller strike price.
Way to go!
A lower strike price on a protective put will lower the premium paid for the insurance. That's because the probability of the underlying reaching the strike is lower.
The probability isn't linear, but it operates in a similar way to a bell curve. That bell curve has a stopping point on the left as the protective put limits the loss. But what's the maximum gain possible?
No.
That's a cost associated with the position, not the amount of the potential gain.
That's not it.
The premium of the put is a cost to the investor, not a potential gain.
That's it!
If you own the stock long with a protective put, you'd have unlimited profit potential because the stock could increase infinitely.
The maximum profit is
$$\displaystyle S_T - S_0 - p_0 = \mbox{Unlimited}$$.
The breakeven is simply the underlying's price increasing to equal the premium.
$$\displaystyle S_0 + p_0$$
But while the breakeven and max profit or loss are calculated based on the underlying's price at initiation, the value at expiration would clearly be based on the underlying's price at the contract's maturity.
The expiration value is
$$\displaystyle Max(S_T,X)$$.
And the profit at expiration is
$$\displaystyle Max(S_T,X) - S_0 - p_0$$.
So the profit at expiration is the expiration value less the underlying's price at initiation and the price of the put.
To summarize:
[[summary]]
A deductible
The potential gain of the put
Equal
Lower
Higher
Unlimited
Premium of the put
Cost of the underlying
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