Key Point - The protective put strategy, when used correctly,
will allow investors to take advantage of some opportunities
that could provide large potential gains without being exposed
to the severe risks that normally accompany such risky opportunities.
With the proper protection in place, the investor can profit
from aggressive upside moves in the value options
a fixed, limited loss.
As stated before, this strategy is not going to work all the
time. However, there are some especially favorable opportunities
for implementing the protective put strategy to value options.
One is the case of value options in the process of a steep decline.
Quite often, value options experience bad news or break down
through a technical support level and trade down to seek a new,
lower trading range.
Everyone wants to find the bottom to buy and go long, catching
the technical rebound, or to start accumulating the value options
at lower levels for the longer term.
Although this scenario sounds good, these types of trades are
risky. The risk is in identifying the true bottom. Value options
that are in a freefall or rapid decline might give a false indication
of a bottom which could lead to substantial losses to your value
options. The protective put will provide protection against
this kind of substantial loss to your value options.
Value options that go through a freefall finally exhausts
or works through the sellers. The value options proceed down
to lower levels where sellers are no longer interested in selling
the value options.
At this level, the value options consolidate and buyers move
in. Because the sellers are now done (exhausted) the pressure
is lifted from the value options and they proceed up as buyers
There are models that are used to calculate where this bottom
may lie, commonly referred to as exhaustion models. The problem
is that the value options, on the way down, may stop and give
the appearance of exhaustion but then continue further down.
If you had bought at the false appearance of exhaustion, you
could be looking at a big loss.
There is a potential for a very big reward if you pick the right
bottom. However, with the big potential gain comes the big potential
loss that is common in these types of risk/reward scenarios.
Here is a perfect opportunity to employ the protective put strategy
to your value options!
Remember, the protective put allows for a large potential upside
with a limited, fixed downside risk. If you feel that the value
options have bottomed out and are starting to consolidate, you
purchase the value options and purchase the put.
If you are right, and the value options run back up, the stock
profit will well exceed the price paid for the put. Once the
value options trade back up, consolidates, and develops its
new trading range, the need for the protective put is over.
At this time, if you still like the value options and want to
hold on to the long position, you could always start selling
calls against it.
Calculate the loss in the value options
and the amount you paid
for the put and add them together for your maximum loss in this
position. The protective put has limited your loss.
Maximum Loss = (Stock Price Strike Price) Option Price
This protection will save you enough money when you pick a false
(wrong) bottom that you may, if you like, try to pick the bottom
again at a lower point. The exhaustion scenario, as described
here, is a perfect opportunity to apply the protective put strategy.
As seen with the exhaustion example, the protective put strategy
is best used in situations where the value options have a potential
for an aggressive upside move and the chance of a big downside