Question

A protective put position is formed by buying the stock and buying a put option on the same stock. Given the following quotations from April 25, 2017 for Amazon stock and an Amazon put option, answer the questions below.

Closing price of Amazon stock = $832 per share.

Option strike price = $800

Closing price of the put option = $18.30

Put option expiration date: June 16, 2017  

a) Plot the payoff and profit diagrams for the protective put position whose components are given above. Make sure that your plots are as informative as positive.  

b) Briefly explain the logic of setting up a protective put position.  


c) Suppose that the investor holds the protective put position till option expiration and that, on June 16, 2017, Amazon stock closes at $720. What is the percentage return to the investor from the entire investment? Compare this rate to the rate of return on a simple buy-and-hold investment in Amazon stock.

Answer 1

The pay off chart of a Protective Put

Payoff from a Put = Max (Break Even Price - Stock Price at Expiry,- Premium)

Break Even Price of Put = Strike Price - Premium = 800 - 18.30 = 781.70

On Expiry Stock closes	Payoff from Stock (held at 832	Payoff from purchased 800Put at 18.30 premium	Net Payoff from Stock & Put
700	-132.00	81.70	-50.30
720	-112.00	61.70	-50.30
740	-92.00	41.70	-50.30
760	-72.00	21.70	-50.30
780	-52.00	1.70	-50.30
800	-32.00	-18.30	-50.30
820	-12.00	-18.30	-30.30
840	8.00	-18.30	-10.30
860	28.00	-18.30	9.70
880	48.00	-18.30	29.70
900	68.00	-18.30	49.70
920	88.00	-18.30	69.70
940	108.00	-18.30	89.70
960	128.00	-18.30	109.70
980	148.00	-18.30	129.70

B. Logic of setting Protective Put -

The main goal of a protective put is to limit potential losses that may result from an unexpected price drop of the underlying asset.

The protective put strategy creates a limit for potential maximum loss, as any losses in the long stock position below the strike price of the put option will be compensated by profits in the option. A protective put strategy is typically employed by bullish investors who want to hedge their long positions in the asset

Adopting such a strategy does not put an absolute limit on potential profits of the investor. Profits from the strategy are found by the price potential of the underlying asset. However, a share of the profits is reduced by the premium paid for the put.

C. If at the expiry the stock closes at 720,

1. The return from futures = 720 - 832 = -112

2. The profit/loss form the Put = Max (Break Even Price - Stock Price at Expiry,- Premium)

= Max(800-18.30 - 720, -18.30)

= Max (61.70, -18.30)

= 61.70

Net Profit / Loss = -112 + 61.70 = - 50.30

Investment in the strategy = Price paid for buying stock + Option Premium paid

= 832 + 18.30

= 850.30

% Return from strategy at expiry ( 720)

= -50.30/ 850.30

= -5.92%

% Return from Buy & Hold = - 112/ 832 = -13.46%

The losses have been considerably reduced by employing the Protective Put strategy