FINRA Series 7Investment Information and Suitable RecommendationsMedium
A client owns 100 shares of XYZ stock, purchased at $80 per share. To protect against a potential decline, they purchase 1 XYZ Oct 75 Put for a premium of $4. What is the maximum loss for this protective put strategy?
- A$400
- B$8,000
- C$7,500
- D$900
Show answer & explanationAnswer & explanation
Correct answer: D. $900
The maximum loss for a protective put occurs if the stock price falls to zero. The put option limits the stock's loss to the strike price. Therefore, the maximum loss is the difference between the stock purchase price and the put's strike price, plus the premium paid.
Why the other options are wrong
- A. This is only the premium paid for the put option, not the maximum potential loss on the entire position.
- B. This represents the initial cost of the stock, not the maximum loss after purchasing the put.
- C. This is the strike price multiplied by 100 shares, ignoring the initial stock cost and premium.
Protective Put Maximum Loss
The maximum loss for a protective put strategy occurs when the underlying stock price falls to zero. The put option limits the downside risk of the stock to its strike price, so the total maximum loss is the difference between the stock's purchase price and the put's strike price, plus the premium paid for the put.
- Strategy involves owning stock and buying a put option.
- Maximum loss is limited to (Stock Purchase Price - Put Strike Price + Premium Paid) x 100 shares.
- Occurs if the stock price drops to zero or below the strike price at expiration.
Memory trick: Protect your stock, pay the put, the loss is limited to your floor.