NASAA Series 65, Uniform Investment Adviser Law ExaminationInvestment Vehicle CharacteristicsMedium
An investor owns 100 shares of XYZ Corp. stock, currently trading at $70 per share. They are concerned about a potential short-term decline in the stock's price but do not wish to sell their shares. They want to protect against a significant loss in value, while still participating in some upside if the stock unexpectedly rises. Which derivative strategy would best suit this objective?
- ASelling a call option on XYZ.
- BBuying a put option on XYZ.
- CBuying a call option on XYZ.
- DSelling a put option on XYZ.
Show answer & explanationAnswer & explanation
Correct answer: B. Buying a put option on XYZ.
Buying a put option grants the right to sell the stock at a specific price, providing downside protection (a floor) while allowing the investor to benefit from any upside appreciation of the stock.
Why the other options are wrong
- A. Selling a call option limits upside potential and provides no downside protection.
- C. Buying a call option is a bullish strategy, providing upside potential but no downside protection for existing shares.
- D. Selling a put option obligates the investor to buy the stock, increasing exposure and offering no protection.
Protective Put Strategy
An option 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 retaining the potential for upside gains.
- Provides downside protection (a floor).
- Retains unlimited upside potential.
- Cost is the premium paid for the put option.
Memory trick: Buying a Put is like 'putting' a safety net under your stock.