Hi Friends, We already discussed the options trading strategy. In this article, we are going to discuss Protective Puts and Long Straddles strategies.
Protective Puts and Long Straddles
Protective puts are bought in an amount sufficient to cover an existing position in an underlying asset. As a result of this strategy, you cannot lose more. Of course, you will have to pay the option’s premium, but it acts as an insurance policy against losses. It is a preferred strategy for traders who own the underlying asset and want downside protection.
It is a long put, just like the strategy we discussed above; however, its aim is to protect against a downside move rather than to profit from it. In the long run, a trader may own bullish shares, but they may want to protect themselves against a decline in the short run. Protective Puts & Long Straddles
At maturity, if the underlying price is above the strike price of the put, the option expires worthless and the trader loses the premium but still benefits from the higher underlying price. However, if the underlying price decreases, the trader’s portfolio position loses value, but this loss is largely compensated by the gains from the put option position. Therefore, this position can be viewed as an insurance policy. Protective Puts and Long Straddles strategies.
Example: Protective Puts
It is possible to reduce premium payments by setting the strike price below the current price at the expense of decreasing downside protection. The following put options are available to investors who buy 1,000 shares of Coca-Cola (KO) at $44 and want to protect the investment from adverse price movements over the next two months. Protective Puts and Long Straddles strategies.
Protective Put Examples
|June 2018 options|
The table shows that the cost of protection climbs with the level of said protection. Using $44 as an example, a trader can buy 10 at-the-money put options for $1.23 per share, in total costing them $1,230. In order to lower costs yet still achieve some level of downside risk reduction, they could opt for the less pricey out-of-the-money option such as a $40 put which would come to only $200.
If the price of the underlying stays the same or rises, the potential loss is limited to the option premium, which is paid as insurance. When the underlying price drops, however, the loss in capital is offset by an increase in the option’s price and is based on the difference between the initial stock price and strike price plus the option premium. With the strike price of $40, the loss is limited to $4.20 per share ($44 – $40 + $0.20).
With a straddle, you can profit from future volatility without having to bet on whether the move will be upward or downward.
It involves purchasing two at-the-money options at the same strike price and expiration on the same underlying. Because it involves purchasing two at-the-money options, it is more expensive than other strategies.
Example: Long Straddles
Someone who expects a particular stock to experience large price fluctuations following an earnings announcement on Jan. 15 is currently buying the stock for $100.
This investor creates a straddle by buying a $5 put option and a $5 call option both at a $100 strike price that will expire on January 30. This straddle has a net option premium of $10. The trader would realize a profit if the price of the underlying security was above $110 (the strike price plus the net option premium) or below $90 (the strike price minus the net option premium) at the time of expiration. Protective Puts and Long Straddles strategies.
Risk/Reward: Protective Puts and Long Straddles
Because a long straddle involves two options, it will cost more than either a call or put on its own. You can only lose a maximum of what you paid for it, but it involves two options. The maximum reward is theoretically unlimited to the upside and limited to the downside by the strike price (for example, if you own a $20 straddle and the stock price goes to zero, you will receive a maximum payout of $20).
Hereafter you have some idea about Protective Puts & Long Straddles options trading. Before entering into trading please refer Investopedia.