As previously stated, when we buy
futures options, three potential
outcomes exist. The futures options can go up, go down, or remain
stagnant. Let's hypothesize results across these three scenarios.
Say you buy the futures options for $31.00 and buy the front
month 30 put for $1.00.
In the up scenario, lets assume the futures options price
is $31.50 at expiration. The results are that you have a $.50
gain from capital appreciation and a $1.00 loss from the purchase
of the put which combined gives us a $.50 overall loss.
It is important to realize that the up scenario will only produce
a positive return if the futures options gain is greater than
the amount paid for the put. That being the case, you calculate
the breakeven point for the protective put strategy by adding
the purchase price of the futures options to the price of the
put.
In the up scenario, add the futures options price $31.00 plus
the option price $1.00 and you get a breakeven of $32.00. So,
until the futures options reach $32.00, the position will not
produce a positive return. Above $32.00 the position will gain
the amount equal to the futures options price minus the premium
paid for the option.
In the stagnant scenario, the position will produce a loss.
Since the futures options havent moved, there will be no capital
gain or loss and with the futures options at $31.00 at expiration,
the puts are worthless. The position lost $1.00, the amount
you paid for the puts.
In the down scenario, the position will again produce a loss.
If the futures options price were to trade down $1.00 to $30.00,
then you would have a $1.00 capital loss.
With the futures options at $30.00, the 30 puts will be worthless,
thus you incur a $1.00 loss because that is what you paid for
them. Your total loss will be $2.00.
However, in the down scenario, the protective put will set
a cap on your losses. Lets see how that works. Well set the
futures options price down to $28.00. Since you purchased the
futures options at $31.00, there will be a capital loss of $3.00.
The puts, however, are now in the money with the futures options
below $30.00. With the futures options at $28.00, the 30 puts
are worth $2.00. You paid $1.00 for them so you have a $1.00
profit in the puts.
Combine the put profit ($1.00) with the capital loss (-$3.00)
and you have an overall loss of $2.00. The $2.00 loss is the
maximum amount you can lose regardless of how low the futures
options decline, even if it goes as low as zero. This is what
is meant by maximum protection.
In every protective put position it is possible to calculate
your anticipated maximum loss. Use the formula: (stock price
minus strike price) minus the options price equals total maximum
loss.
Maximum Loss = (Stock Price Strike Price) Option Price
For example, suppose you paid $30.00 for your stock. You bought
the front month 27.5 put for $1.00. Next, assume the stock closes
at $27.50 on expiration day.
Your maximum loss calculation would be:
($30.00 $ 27.50) - $1.00 = $3.50
$30.00 (stock price) minus 27.5 (strike price) equals a $2.50
capital loss. Do not forget that with the stock at $27.50, the
27.5 puts will be worthless.
Add the capital loss ($2.50) plus the option loss ($1.00). The
total is $3.50 which is your maximum possible loss in that position.
This formula will work every time.
Looking at the three hypothesized scenarios, we find that only
one scenario, the up scenario, can produce a positive return
and thats only when the futures options increase more than
the amount you paid for the puts.
The other two scenarios produced losses. If the futures options
are stagnant, you lose the amount you paid for the put. If the
futures options go down, you lose again- but the loss is limited.
It is the limiting of loss that makes the protective put an
attractive and useful strategy.