NASAA Series 66 Uniform Combined State Law ExaminationClient Investment Recommendations and StrategiesMedium
A client owns 100 shares of XYZ Corp. stock, which they purchased at $50 per share. The stock is currently trading at $70 per share. The client wants to protect their unrealized gains but is unwilling to sell the stock at this time. Which of the following strategies would best achieve this objective?
- APlacing a stop-limit order to sell at $65.
- BSelling XYZ Corp. stock short.
- CBuying a protective put option on XYZ Corp. stock.
- DSelling a covered call option on XYZ Corp. stock.
Show answer & explanationAnswer & explanation
Correct answer: C. Buying a protective put option on XYZ Corp. stock.
Buying a protective put option gives the client the right to sell their shares at a predetermined price (the strike price) before expiration, regardless of how far the market price falls. This effectively sets a floor on the potential loss, protecting unrealized gains while allowing the client to continue holding the stock and participate in further upside.
Why the other options are wrong
- A. A stop-limit order would sell the stock if it falls to a certain price, but the client explicitly states they 'are unwilling to sell the stock at this time' and wants to protect gains while holding.
- B. Selling stock short is a bearish strategy that profits from a decline, but the client owns the stock and wants to protect gains, not speculate on a fall.
- D. Selling a covered call would generate income but would cap the upside potential and not protect against a downward move.
Protective Put
An options strategy where an investor who owns a stock buys a put option on that same stock to protect against a decline in its price, while still retaining upside potential.
- Acts like an insurance policy for the stock holding.
- Sets a floor (strike price) below which the stock's value cannot fall.
- Cost is the premium paid for the put option.
Memory trick: Put protects the fall; call caps the rise; collar combines both for a wise price.