A client buys 100 shares of XYZ stock at $80 per share. To protect against a decline, the client buys 1 XYZ 75 put for $5. What is the maximum loss this investor can incur on this protective put strategy?
- A$500
- B$800
- CUnlimited
- D$1,000
Show answer & explanationAnswer & explanation
Correct answer: D. $1,000
This is a protective put strategy. The maximum loss occurs when the stock price falls below the put's strike price. The put limits the downside loss on the stock to the difference between the stock purchase price and the put's strike price, plus the premium paid for the put. Loss = (Stock Purchase Price - Put Strike Price) + Put Premium = ($80 - $75) + $5 = $5 + $5 = $10 per share. For 100 shares, the maximum loss is $10 * 100 = $1,000.
Why the other options are wrong
- A. This only represents the premium paid for the put option. The loss includes the stock's decline down to the strike price.
- B. This calculation is incorrect. It might be the stock price minus the premium ($80-$5) x 100, which is not the max loss.
- C. Loss is limited by the put option, so it is not unlimited.
Protective Put Maximum Loss
The largest potential loss for an investor holding a protective put (long stock + long put), which is limited to the difference between the stock purchase price and the put's strike price, plus the premium paid for the put.
- The put option establishes a floor, preventing further losses below the strike price.
- The cost of the put premium adds to the overall potential loss.
- Occurs if the stock price falls to or below the put's strike price.
Memory trick: Put limits stock fall, but its cost adds to loss.