A protective put strategy is designed to: Question 5Answer a. Leverage gains through buying calls. b. Profit from high market volatility. c. Limit losses on a stock by buying a put option. d. Generate income by selling a call option.
The correct answer and explanation is:
The correct answer is:
c. Limit losses on a stock by buying a put option.
Explanation:
A protective put strategy is an options strategy used by investors who already own the underlying stock and want to protect themselves against potential downside risk. This strategy involves buying a put option on the stock that the investor holds.
A put option gives the holder the right, but not the obligation, to sell the underlying stock at a predetermined price called the strike price before the option expires. By purchasing a put option, the investor essentially buys insurance against a drop in the stock’s price.
Here’s how the protective put works:
- Stock Ownership: The investor owns shares of the stock.
- Put Option Purchase: The investor buys a put option for the same stock with a strike price typically near the current stock price.
- Downside Protection: If the stock price falls below the strike price, the put option increases in value, offsetting losses from the declining stock. The investor can exercise the put to sell the stock at the strike price, limiting their loss.
- Upside Potential: If the stock price rises, the put option may expire worthless, but the investor still benefits from the stock’s price appreciation. The only cost is the premium paid for the put option.
Why other options are incorrect:
- a. Leverage gains through buying calls: This describes a call option strategy, not a protective put.
- b. Profit from high market volatility: Strategies that profit from volatility typically involve straddles or strangles, not protective puts.
- d. Generate income by selling a call option: This describes a covered call strategy, not a protective put.
Summary:
The protective put strategy acts like insurance for stockholders. It limits potential losses if the stock price falls, while still allowing for unlimited gains if the stock price rises. The cost of this insurance is the premium paid for the put option. This strategy is widely used to manage risk, especially during uncertain or volatile market conditions.