Protective Put Strategy For Futures Options In Different Scenarios

Provided By Options University

How To Apply This Strategy To Trading Futures Options

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, let’s 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 haven’t 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. Let’s see how that works. We’ll 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 option’s 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 that’s 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.

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