CFA Level II ExamPortfolio Management and Wealth PlanningMedium
A pension fund manager holds a large equity portfolio and is concerned about potential downside risk over the next three months. The manager wants to protect against a significant market decline but also wants to maintain exposure to potential upside gains. Which of the following option strategies would be most appropriate for this objective?
- ASelling covered calls
- BBuying a straddle
- CSelling naked puts
- DBuying protective puts
Show answer & explanationAnswer & explanation
Correct answer: D. Buying protective puts
Buying protective puts involves purchasing put options on an existing long position. This strategy provides downside protection below the strike price of the put while allowing the investor to participate in any upside gains of the underlying asset, exactly matching the manager's objective.
Why the other options are wrong
- A. Selling covered calls generates income but limits upside potential beyond the call's strike price.
- B. Buying a straddle involves buying both a call and a put with the same strike and expiry, profiting from large price movements in either direction, but is expensive and doesn't explicitly protect an existing long position while maintaining upside.
- C. Selling naked puts obligates the seller to buy the stock if it falls below the strike, exposing them to significant downside risk, which is the opposite of the manager's objective.
Protective Put Strategy
A protective put strategy involves buying a put option on a stock or portfolio already owned, providing a hedge against potential price declines while retaining upside potential.
- Combines a long stock position with a long put option.
- Provides downside protection (floor) below the put's strike price.
- Retains unlimited upside potential.
- Cost is the premium paid for the put option.
Memory trick: Protective Puts Protect Profits and still let you Soar!