NASAA Series 65, Uniform Investment Adviser Law ExaminationInvestment Vehicle CharacteristicsMedium
An investor owns 100 shares of XYZ Corp. common stock, currently trading at $60 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 hedge against this downside risk while still participating in some upside if the stock rises, they decide to buy a put option on XYZ Corp. with a strike price of $55. This strategy is known as a:
- AProtective Put
- BCovered Call
- CShort Strangle
- DLong Straddle
Show answer & explanationAnswer & explanation
Correct answer: A. Protective Put
Buying a put option on a stock you own to hedge against a decline in its price is known as a protective put strategy, allowing participation in upside while limiting downside.
Why the other options are wrong
- B. A covered call involves selling a call option on stock you own to generate income, not primarily to protect against downside risk.
- C. A short strangle involves selling an out-of-the-money call and an out-of-the-money put, used when expecting low volatility.
- D. A long straddle involves buying both a call and a put with the same strike price and expiration, used when expecting significant price movement in either direction.
Protective Put
An options strategy involving buying a put option on a stock that the investor already owns to protect against a decline in the stock's price.
- Used to hedge against downside risk in a long stock position
- Limits potential losses below the put's strike price
- Allows for participation in potential upside gains of the stock
Memory trick: Protective Put: Puts a floor on your stock's Price.