Question

Why is choosing an exercise price on a protective out like deciding which deductible to take on an insurance policy?

Answer 1

A protective put is a strategy of buying a put option to protect from the downside risk of a stock.

When we buy a stock, we can gain unlimited as the stock price goes up, in case the stock price falls, we will lose the amount of money from the stock price to the strike price . Once, the stock falls below the strike price we can gain on the put option and protect ourselves form losses due to the falling stock prices.

Here, the higher the strike price means more premium has to be paid to protect from losses due to falling prices. So, comparing with insurance , in the case of insurance policy , the insurer has to pay a deductible before the insurance company begins compensating for the losses incurred by the insured. Options are often described as a form of insurance. As, longer the term of the insurance the higher is the premium similar to a put option, the 4 month put is more expensive than a 2 month put option. Higher the deductible of an insurance policy means lower premium costs.

Example: A stock trades at $51,  buying a put option at  strike price of $48, we will have to pay a premium of $2 and a put option with a strike price of $45 will charge a premium of $0.5.

The put option with a strike price of $48 has a lower deductible compared with a put option at strike price of $45.

If we want a lower deductible in insurance  which is the higher strike price($48) in the case of a put option then we hay to pay higher premium cost. The higher the strike price, the lower is the deductible and hence the premium cost of buying the put option is higher which is similar to an insurance policy. The lower the deductible in the case of an insurance policy, the higher premium has to be paid as a result.

So, choosing an exercise price on a protective put is similar to choosing a deductible on an insurance policy.