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 stock while
having 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.
One is the case of a stock in the process of a steep decline.
Quite often, stocks 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 stock 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. A stock that
is in a freefall or rapid decline might give a false indication
of a bottom which could lead to substantial losses. The
protective put will provide protection against this kind of
substantial loss.
A stock that goes through a freefall finally “exhausts” or works
through the sellers. The stock proceeds down to lower levels
where sellers are no longer interested in selling the stock.
At this level, the stock consolidates and buyers move in.
Because the sellers are now done (exhausted) the pressure is
lifted from the stock and it proceeds up as buyers out-number
sellers.
There are models that are used to calculate where this bottom
may lie, commonly referred to as “exhaustion models.” The
problem is that the stock, 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!
Remember, the protective put allows for a large potential upside
with a limited, fixed downside risk. If you feel that the stock
has bottomed out and is starting to consolidate, you purchase
the stock and purchase the put.
If you are right, and the stock runs back up, the stock profit
will well exceed the price paid for the put. Once the stock
trades 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 stock and want to hold on to the long
position, you could always start selling calls against it.
Use the formula for maximum loss discussed earlier. Calculate
the loss in the stock 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 stock has a potential for
an aggressive upside move and the chance of a big downside move.
Another potential opportunity for using the protective put 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 future
stock movements.
Stocks 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 stock where its 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 stock is
considered to have “broken out” of its trading range and will
now often trade higher, and establish a new higher trading
range.
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 stock 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. 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 stock (when it
trades through $66.00), you would buy the stock immediately.
The risk of the stock not following through with its breakout is
not large but it does happen. The stock could trade back down to
$58.00 which is the bottom of the trading range. If you had
bought the stock naked above $66.00, you would realize a minimum
$8.00 loss.
However, if you were to apply a protective put strategy with the
stock purchase, you can drastically limit your downside
exposure. For instance, say you were to buy the 65 strike put
for $2.00. If the stock trades up to $75.00, you would make
$9.00 if done naked but only make $7.00 if done with the
protective put.
This difference is the cost of the put. This $2.00 investment is
more than worth it should the stock go down. If the break-out
turns out to be a “false” break-out and the stock reverses and
trades down, your 65 put will allow you to sell your stock 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.
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