CFA Level II ExamDerivativesMedium
A portfolio manager holds a long position in a stock currently trading at $70. To protect against a moderate decline in the stock price while still allowing for some upside potential, the manager implements a partial hedge using a protective put strategy. The manager buys a put option with a strike price of $65 for a premium of $2.00. What is the maximum loss per share the manager could incur with this strategy, ignoring transaction costs?
- A$2.00
- B$7.00
- C$5.00
- D$9.00
Show answer & explanationAnswer & explanation
Correct answer: B. $7.00
A protective put strategy consists of holding the underlying stock and buying a put option. The maximum loss occurs if the stock price falls below the strike price. The loss is capped at (Stock Purchase Price - Strike Price) + Premium Paid. Here, since the stock is already held at $70, the maximum loss is ($70 - $65) + $2.00 = $5 + $2 = $7 per share.
Why the other options are wrong
- A. Incorrect; this is just the premium paid.
- C. Incorrect; this is the difference between the stock price and the strike price, but ignores the premium paid.
- D. Incorrect; calculation error, possibly adding the strike price to the premium.
Protective Put Maximum Loss
The maximum loss for a protective put strategy is limited and occurs if the stock price falls below the put option's strike price.
- It is calculated as the initial stock purchase price minus the put option's strike price, plus the premium paid for the put.
- The strategy involves owning the underlying stock and buying a put option.
- It provides downside protection below the strike price.
Memory trick: Protective Put: Stock + Bought Put, Loss Stops at Strike + Premium!