A sophisticated investor is looking to speculate on a significant decline in the price of XYZ stock, currently trading at $70. They want to maximize leverage and profit potential from a downward move, but are also aware of the time decay associated with their chosen instrument. Which derivative strategy would best suit their objective?
- ASell a Put Option on XYZ
- BBuy a Call Option on XYZ
- CSell XYZ Stock Short
- DBuy a Put Option on XYZ
Show answer & explanationAnswer & explanation
Correct answer: D. Buy a Put Option on XYZ
Buying a put option gives the holder the right to sell the underlying stock at a specified strike price. If the stock price declines significantly, the value of the put option will increase, offering substantial leverage and profit potential from a downward move. However, options are wasting assets and are subject to time decay, which aligns with the investor's awareness. Selling XYZ stock short also profits from a decline but offers less leverage and has unlimited loss potential, unlike buying a put.
Why the other options are wrong
- A. Selling a put option profits if the stock price stays above the strike price or increases, not from a significant decline.
- B. Buying a call option profits from a price increase, opposite of the client's objective.
- C. Selling stock short profits from a decline but involves higher risk (unlimited loss potential) and typically less leverage than buying an out-of-the-money put option, and is not a derivative strategy.
Long Put Option
The purchase of a put option, granting the buyer the right, but not the obligation, to sell the underlying asset at a specified strike price before or on the expiration date.
- Profits from a decline in the underlying asset's price.
- Maximum loss is the premium paid.
- Offers significant leverage.
- Subject to time decay (wasting asset).
Memory trick: Puts for downward moves, short sells for big falls.