An investor owns 100 shares of ABC stock, currently trading at $60 per share. To protect against a potential short-term decline in the stock's price, the investor decides to purchase an ABC Jul 55 Put option for a premium of $3 per share. What is the maximum potential loss for the investor on their stock position if the stock price drops to $40 and the put is exercised?
- A$500
- B$800
- C$300
- D$200
Show answer & explanationAnswer & explanation
Correct answer: B. $800
The investor owns 100 shares at $60, so their initial stock value is $6,000. They bought a put with a strike price of $55, allowing them to sell at $55 even if the market price drops. The cost of the put was $3 per share, or $300 for 100 shares. If the stock drops to $40 and they exercise the put, they sell the 100 shares at $55, receiving $5,500. Their total cost was $6,000 (stock) + $300 (premium) = $6,300. Their proceeds are $5,500. The loss is $6,300 - $5,500 = $800. The put effectively capped the loss on the stock at $5 per share ($60 current price - $55 strike price) plus the premium paid for the put ($3 per share). So, a loss of $5 + $3 = $8 per share, or $800 for 100 shares.
Why the other options are wrong
- A. This is the loss on the stock if it dropped to $55 and the put was free ($60 - $55 = $5 per share).
- C. This is the cost of the put option premium.
- D. This would be the loss if the stock only dropped to $58 (cost $60 - $58 current) and no option was involved, or if the option was free.
Protective Put Strategy
An options strategy involving buying a put option on a stock that is already owned. It acts as an insurance policy, setting a floor on the potential loss of the stock position.
- Investor is long stock and long put.
- Limits downside risk on the stock.
- Cost of protection is the put premium.
Memory trick: Protecting Puts Prevents Price Plunges.