NASAA Series 65, Uniform Investment Adviser Law ExaminationInvestment Vehicle CharacteristicsMedium
An investor owns 100 shares of ABC stock, currently trading at $50 per share. They are concerned about a potential short-term decline in the stock's price but do not want to sell their shares. To protect against this downside risk, they decide to purchase an option contract. Which of the following strategies are they employing?
- ABuying a call option
- BSelling a covered call
- CBuying a put option
- DSelling a naked put
Show answer & explanationAnswer & explanation
Correct answer: C. Buying a put option
Buying a put option gives the investor the right to sell their shares at a predetermined strike price, thus protecting against a decline in the stock's market price below that strike price.
Why the other options are wrong
- A. Buying a call option is a bullish strategy used to profit from an increase in stock price, not to protect against a decline.
- B. Selling a covered call is an income-generating strategy that limits upside potential and offers limited downside protection only up to the premium received.
- D. Selling a naked put is a bullish strategy that obligates the seller to buy the stock if the price falls, exposing them to significant downside risk.
Protective Put
An options strategy where an investor buys a put option on a stock they already own to protect against a decline in the stock's price.
- Acts like an insurance policy for the stock holding.
- Limits potential losses to the strike price minus the premium paid.
- Allows the investor to retain ownership of the stock and benefit from any upside.
- Suitable for investors who are bullish long-term but bearish short-term.
Memory trick: Protective Put: 'P'rotects your 'P'ortfolio when prices fall.