2. Option Strategies

An investor who is long stock and wishes to protect the position from downside risk will receive the most protection by purchasing a protective put. By purchasing the put, the investor has locked in or set a minimum sale price that they will receive in the event of the stock’s decline for the life of the put. The minimum sale price in this case is equal to the strike price of the put. Long puts can be used with long stock to guard against a loss or to protect an unrealized profit. However, by purchasing the put, the investor has increased their breakeven point by the amount of the premium they paid to purchase the put. When looking to establish a long stock long put position, the investor must determine:

• Their Maximum Gain
• Their Breakeven
• Their Maximum Loss

Maximum Gain Long Stock Long Puts

An investor who is long stock and long puts has a maximum gain that is unlimited because they own the stock.

Breakeven Long Stock Long Puts

To determine an investor’s breakeven when they have established a long stock long put position you must add the option premium to the cost of the stock.

Breakeven = Stock Price + Premium

Example:

An investor establishes the following position:

Long 100 XYZ at 55

Long 1 XYZ June 55 put at 3

The investor will breakeven if the stock goes to \$58. The stock price has to appreciate by enough to offset the amount of the premium that the investor paid for the option. If at expiration, the stock is at \$58 per share and the put expires, the investor will have broken even, excluding transaction costs.

Maximum Loss Long Stock Long Puts

In order to determine an investor’s maximum loss when they have established a long stock long put position, you must first determine the breakeven as outlined above. Once you have determined the breakeven, use the following formula:

Maximum Loss = Breakeven – Strike Price

Let’s take another look at the previous example, only this time we will use it to determine the investor’s maximum loss.

Example:

An investor establishes the following position:

Long 100 XYZ at 55

Long 1 XYZ June 55 put at 3

We have already determined that the investor will breakeven if the stock goes to \$58. To determine their maximum loss, we subtract the put’s strike price from the investor’s breakeven as follows:

58 – 55 = 3

The investor’s maximum loss is \$3 per share or \$300 for the entire position. Notice that the option’s premium is the investor’s maximum loss. When the purchase price of the stock and the strike price of the put are the same, the investor’s maximum loss is equal to the premium paid for the option.

Let’s take a look at another example where the investor’s purchase price is different from the strike price of the put.

Example:

An investor establishes the following position:

Long 100 XYZ at 58

Long 1 XYZ June 55 put at 2

In order to find the investor’s maximum loss, we first need to determine their breakeven. This investor will breakeven if the stock goes to \$60, found by adding the stock price to the premium the investor paid for the put. To find their maximum loss, we subtract the put’s strike price from the breakeven.

60 - 55 = 5

The investor’s maximum loss on this position is \$5 per share or \$500 for the entire position.

An investor who is long stock and long puts has limited their potential losses and has received the maximum possible protection while retaining all of the appreciation potential.

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Long Stock Short Calls / Covered Calls

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