Another potential opportunity for using the protective put with
value options is in combination with Technical Analysis. Technical
Analysis is the study of charts, indicators oscillators, etc.
Charting has proven to be more than reasonably accurate in forecasting
the movements of future value options
Value options travel in cycles that can and do form repetitious
patterns. These patterns are predictable and detectable by the
use of any number of charts, indicators and oscillators.
Although there are many, many forms and styles of technical
analysis, they all have several similarities. The one we want
to focus on is the technical break-out. A break-out is described
as a movement of the value options where their price trades
quickly through and beyond an obvious technical resistance
or resistance point.
For a bullish breakout, this level is at the very top of its
present trading range. Once through that level, the value options
are considered to have broken out of its trading range and
will now often trade higher, and establish a new higher trading
The break-out is normally a rapid, large upward movement that
usually offers an outstanding potential return if identified
properly and acted upon in a timely fashion. However, if the
break-out fails, the value options could trade back down to
the bottom of the previous trading range.
If this were to happen, you would have incurred a large loss
because you would have bought at the upper end of the previous
trading range for the value options. As you can see the break-out
scenario is an opportunity that has large potential rewards
but can on occasion, have a large downside risk.
Therefore, this is an excellent scenario for application of
the protective put strategy.
For example, XYZ is presently at the top of a trading range
with the upper end of the range being $66.00 and the bottom
end of the range being $58.00. When the chart, indicator, or
oscillator you are using identifies the break-out of the value
options (when it trades through $66.00), you would buy the value
The risk of the value options not following through with its
breakout is not large but it does happen. The value options
could trade back down to $58.00 which is the bottom of the trading
range. If you had bought the value options naked above $66.00,
you would realize a minimum $8.00 loss.
However, if you were to apply a protective put strategy with
the value options purchase, you can drastically limit your downside
exposure. For instance, say you were to buy the 65 strike put
for $2.00. If the value options trades up to $75.00, you would
make $9.00 if done naked but only make $7.00 if done with the
This difference is the cost of the put. This $2.00 investment
is more than worth it should the value options
go down. If the
break-out turns out to be a false break-out and the value
options reverse and trades down, your 65 put will allow you
to sell your value options out at $65.00 minus the $2.00 you
paid for the put. This limits your loss to $3.00 instead of
a potential $8.00 loss. This is a much better risk/reward scenario.