Before every protective put trade it is possible to calculate
your anticipated maximum loss. Use the formula: (stock price
minus strike price) plus option price. For example, suppose you
will pay $30.00 for your stock, and you want no more than a $3.50
loss on the position. Then you would choose the $27.50 strike
put which costs $1.00. Following the formula, you take your
stock price ($30.00) and subtract the put's strike price (27.50)
which leaves you $2.50. To this $2.50 loss, you then add the
amount you spent on the option ($1.00), which gives you a
combined, maximum loss of $3.50 for this position. You can set
your loss limit by the strike price of the put you buy and the
cost of the put. This formula will work every time. Remember,
stock loss, (stock price paid - strike price), plus option cost
(option price) equals maximum potential position loss.
The protective put strategy, when used correctly, will allow
investors to take advantage of the same opportunities that could
provide large potential gains, but without being exposed to the
extreme risks the position could potentially present. In these
scenarios, the protective put strategy deserves consideration.
For example, a stock in the process of a steep decline would be a
good opportunity to implement a protective put, when trying to
pick a bottom. Quite often, stocks experience bad news or break
down through a technical support level and trade down to seek a
new, lower trading range.
Everyone wants to find the bottom to buy and go long, catching
the technical rebound, or to start accumulating the stock at
lower levels for the longer term.
There is a potential for a very big reward if you pick the
"right" bottom. However, with the big potential gain comes the
big potential loss that is common in these types of risk/reward
scenarios. Here is a perfect opportunity to employ the protective
put strategy! It will provide protection against substantial
loss, while allowing room for potential gains if the stock should
bounce.
Remember, the protective put allows for a large potential upside
with a limited, fixed downside risk. If you feel that the stock
has bottomed out and is starting to consolidate, you purchase the
stock and then purchase the put at the same time as insurance
against further decline in the stock.
If you are right, and the stock runs back up, the stock profit
will well exceed the price paid for the put. Once the stock
trades back up, consolidates, and develops its new trading range,
the need for the protective put is over. At this time, if you
still like the stock and want to hold on to the long position,
you could always start selling calls against it.
Use the formula for maximum loss discussed earlier. Calculate the
loss in the stock and the amount you paid for the put and add
them together for your maximum loss in this position. The
protective put has limited your loss.
Maximum Loss = (Stock Price - Strike Price) + Option Price
This protection will save you enough money when you pick a false
(wrong) bottom that you may, if you like, try to pick the bottom
again at a lower point. The exhaustion scenario, as described
here, is a perfect opportunity to apply the protective put
strategy.
As seen with the exhaustion example, the protective put strategy
is best used in situations where the stock has a potential for an
aggressive upside move and the chance of a big downside move.
Another potential opportunity for using the protective put is in
combination with Technical Analysis. Technical Analysis is the
study of charts, indicators oscillators, etc. Charting has
proven to be reasonably accurate in forecasting future stock
movements.
Stocks travel in cycles that can and do form repetitious
patterns. These patterns are predictable and detectable by the
use of any number of charts, indicators and oscillators.
Although there are many, many forms and styles of technical
analysis, they all have several similarities. The one we want to
focus on is the technical "break-out." A break-out is described
as a movement of the stock where its price trades quickly through
and beyond an obvious "technical resistance" or resistance point.
For a bullish breakout, this level is at the very top of its
present trading range. Once through that level, the stock is
considered to have "broken out" of its trading range and will now
often trade higher, and establish a new higher trading range.
The "break-out" is normally a rapid, large upward movement that
usually offers an outstanding potential return if identified
properly and acted upon in a timely fashion. However, if the
break-out fails, the stock could trade back down to the bottom of
the previous trading range.
If this were to happen, you would have incurred a large loss
because you would have bought at the upper end of the previous
trading range. As you can see the "break-out" scenario is an
opportunity that has large potential rewards but can on occasion,
have a large downside risk.
However, if you were to apply a protective put strategy with the
stock purchase, you can drastically limit your downside exposure.
For instance, say you were to buy the 65 strike put for $2.00.
If the stock trades up to $75.00, you would make $9.00 if done
naked but only make $7.00 if done with the protective put.
This difference is the cost of the put. This $2.00 investment is
more than worth it should the stock go down. If the break-out
turns out to be a "false" break-out and the stock reverses and
trades down, your 65 put will allow you to sell your stock out at
$65.00 minus the $2.00 you paid for the put. This limits your
loss to $3.00 instead of a potential $8.00 loss. This is a much
better risk/reward scenario.
Most professional traders, including day traders and swing
traders can reap huge rewards for the protective put strategy.
The reason is in how most traders attain profits and losses.
Normally, successful traders make a little money on a consistent
basis. They make a little bit day in and day out. But when it
comes to losses, they lose in large chunks. They spend a month
building up profits only to lose that money in one day usually in
one stock. If a trader could figure out how to avoid even a
handful of these large losses, his or her profitability would
soar. My answer is to start using the protective put when buying
on breakouts and when bottom fishing.
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