Buying a Put Option to Protect a Profit




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Suppose that when the Put option expires, the stock has declined to 30. Without the protection of the Put option, the man's profit would have been lost, but through the terms of his Put contract he delivers his stock at 50 to the maker of the option. The 20 points that he has saved through the use of his Put has certainly more than paid for the cost of the option. He can, if he cares to, now repurchase at 30 the stock that he sold at 50 through exercising his Put option.

A Man Owns 100 Shares Of Stock Which He Bought At 30 Four Months Ago

Now the stock is selling at 50. Concerned about conditions but feeling that his stock can do still better, he buys a Put contract at 50, good for 90 days, for $350. I would like to call the attention of the reader to the fact that the $350 paid for the protective Put can easily be more than made up by the fluctuations of the stock in the next 90 days.

Suppose that when the Put option expires, the stock has declined to 30. Without the protection of the Put option, the man's profit would have been lost, but through the terms of his Put contract he delivers his stock at 50 to the maker of the option. The 20 points that he has saved through the use of his Put has certainly more than paid for the cost of the option. He can, if he cares to, now repurchase at 30 the stock that he sold at 50 through exercising his Put option.

On the other hand, let us suppose that when the Put expires, the stock has advanced to 70. While the buyer then allows his option to expire (he wouldn't Put stock at 50 when he can sell it in the market at 70) the 20 points appreciation in the stock has more than made up the cost of the Put. Only if the stock is at about the same price of 50 when the option expires will the $350 paid for the contract be an actual loss. Even then it must be admitted that the Put has furnished protection during the period of the option.

Note that the holder of an option will and should exercise his contract even if the exercise will return to him only part of the cost. If the holder of a Put at 50 finds that at expiration the stock is selling at 48, or even 49, the contract should be exercised so as to recover part of the premium instead of losing all of it.

Bought Put at 50-cost

$350

Sold Stock at 50 by exercising Put

$5,000

Bought Stock in market at 48 $4,800
Profit on Stock $200
Loss between profit on stock & cost of Put Option.

$150




An option should be exercised even if only part of its cost can be salvaged.

Buying a Put Option to Protect an Initial Commitment

Feeling bullish on a stock, a man wants to buy 100 shares but does not want to assume a big risk. He buys 100 shares at 50 and at the same time buys a Put option at 50, good for 90 days, at a cost of $350. Through the protection of his option, he knows that he can share in any rise of the stock but his loss will be limited to the cost of his Put contract. To be practical, let us see what happens if the stock goes up to 70, as he expects, or what happens if he is wrong and the stock goes down to 30. In the first instance he would sell out his stock at 70 and let the Put option lapse, and his account would read:

Bought 100 shares at 50

$5,000

Bought Put 100 shares at 50-cost

$350

Total Cost $5,350
Sold 100 shares at 70 $7,000
Profit

$1,650




This profit has been made with a risk of $350.

If he had been wrong and the stock had declined to 30, his account would have read:

Bought 100 shares at 50

$5,000

Bought Put 100 shares

$350

Total Cost $5,350
Sold 100 shares at 50 (through Put) $5,000
Loss

$350




Note that he sold his stock at 50 (at cost) through the terms of his Put contract, even though the stock had declined to and was selling at 30.

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