CFA Level 1 Derivatives - Risk Management Applications Option

Risk Management Applications of Option Strategies - Protective put Strategy


LOS
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b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
a protective put strategy, and explain the risk management application of the strategy.
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A protective put is a put bought to hedge an existing holding of a security. It provides protection against decline in value of the security.

If CP (current price) and TP(terminal price at maturity) on the cash security a profit is realized if TP>CP.

On the put, if TP>CP loss made to the extent of premium.
If TPThe value of the put will be maximum of [0, X-TP].
Profit will be maximum of [0, X-TP] minus the premium paid.

Example: An investor bought a put at strike price $100 for a stock quoting at $100. the premium paid is $5.

If the price remains at $100 at the expiry day, value of the put is zero and the loss of the investment strategy is $5 in comparison to unhedged position.

If the price goes to $98, value of the put is $2 and the loss of the investment strategy is $3 in comparison to unhedged position.

If the price goes to $95 value of the put is $5 and the loss of the investment is strategy is zero compared to unhedged position.

If the price goes up to $105, the investor makes only 100$ because of the premium paid on put. As price at maturity goes higher, investor makes profit.

Thus maximum loss this investment strategy is $5 and upside is available without any cap. So this strategy has a payoff similar to long call.