Tuesday, August 4, 2015

Buying Stock - Hedging with long puts - Series 7 Options Help

Buying stock and hedging with puts is a popular strategy for investors and is part of the Series 7 test when dealing with Stock and Option combo scenarios.

Main thing to remember with Long Stock and Long Put set ups is ALWAYS focus on the stock when it comes to maximum gain, maximum loss and break even. 

The Put Option is basically a "stop loss order" that is controlled by you - until the option expires. As opposed to a stop order that will automatically get triggered. Puts cost a premium, but they allow YOU the choice of whether to use it or not.

Stock and Put Example

BUY 100 Shares DFG at $78
BUY 1 DEC DFG 75 Put for $200

Key here is the investor wants the stock to go up. He has $7800 Invested in the stock alone. The $200 premium is added to his cost for protection. So, his cost is $8000 or $80. That is the break-even 80. Should the stock rise above 80 and stay there past the option expiration, it is pure profit for him and he will either allow the option to expire or perhaps trade it away for something back $ wise.

When you buy puts by themselves, you want the stock to go down but when they are placed 1 for 1 with long shares of stock, the person does not want the stock to go down. It is a Hedge.

Maximum Gain 

Maximum gain is unlimited because the stock can rise to an unlimited level. The premium will ultimately be deducted, but that is not able to calculated exactly, so unlimited is always the answer when you are long stock and long options. It will be a choice on the Series 7 exam.

Maximum Loss

This is why the Put was purchased - to limit the loss. Normally, the potential loss would be the whole stock value. In this case, $7800, but since the Put gives the holder the right to sell the stock or "put" it to someone at 75, the max stock part of the loss is $300. Then you add the premium cost of $200, which was paid up front when the option contract was purchased and that equals $500.

So, the maximum loss in this set up is $500

Always remember on the Series 7 or any exam where options are asked is to FOCUS ON THE STOCK when looking at gains losses and break-evens. The option is used for protection when LONG the option or it is used for income when selling or shorting a Call Option.

To learn about Covered Call Writing with Stock, Visit American Investment Training's Free Glossary and definitions Here:   Covered Call and Stock Strategies

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