NASAA Series 66 Uniform Combined State Law ExaminationClient Investment Recommendations and StrategiesHard
A client holds 100 shares of XYZ Corp. stock, which they purchased at $50 per share. The stock is currently trading at $60 per share. The client is concerned about a potential short-term decline in the stock's price but does not want to sell their shares. To protect against a significant loss while retaining ownership, the client should consider:
- ASelling a covered call option on XYZ Corp.
- BBuying a protective put option on XYZ Corp.
- CImplementing a stop-loss order below the current market price.
- DBuying more shares of XYZ Corp. to average down their cost basis.
Show answer & explanationAnswer & explanation
Correct answer: B. Buying a protective put option on XYZ Corp.
Buying a protective put option gives the investor the right to sell the stock at a specified strike price, thereby setting a floor for potential losses while allowing upside participation if the stock price rises. A stop-loss order might be triggered by temporary volatility, forcing a sale.
Why the other options are wrong
- A. Selling a covered call would generate income but would cap the client's upside potential if the stock price rises significantly, and does not provide protection against a fall below the current price.
- C. While a stop-loss order limits losses, it would result in the sale of the shares, which the client explicitly stated they do not want to do, and could be triggered by temporary market fluctuations.
- D. Buying more shares would increase exposure and average down the cost basis, but would not protect against a short-term decline; it would increase potential losses.
Protective Put
An options strategy involving buying a put option on a stock already owned, providing a hedge against a decline in the stock's price while allowing the investor to profit from potential upward movements.
- Limits downside risk by setting a floor (strike price) for the stock.
- Allows the investor to retain ownership of the underlying stock.
- Cost of the put option reduces potential profits.
- Used when an investor is bullish long-term but bearish short-term.
Memory trick: To protect your stock, buy a put's lock, keep your shares, avoid market scares.