There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
One of the most basic protective positions is a married put, also known as a protective put.
Buying some protection
A married put is a strategy where a long investor purchases a put option that typically will have a strike price lower than the current stock price. By owning the put as well as the stock, the investor is protected from any downside below the put's strike price, since the investor can exercise the put and sell the underlying. Simply put (no pun intended), buying a protective put is similar to buying insurance against a stock's decline.
For example, let's say that a stock is trading at $50 and you purchase the underlying shares at $50. If you wanted to protect against the possibility of the stock falling below $40, you could purchase a $40 put. Let's assume that the premium for the put is $4.
Maximum loss: cost basis of underlying stock minus strike price, plus premium paid
The most that you can lose on a protective put is the difference between what you paid for the stock and the strike price of the put, in addition to the premium paid for the put.
In this example, if you bought the stock at $50 along with a $40 put for $4, and the stock declined to any price less than or equal to $40, you would exercise the put and sell the stock at $40. That would translate into a loss of $10 per share, and you would also lose the $4 premium for total losses of $14.
Maximum gain: unlimited
A married put's theoretically maximum gain is unlimited, simply due to the long stock position since stock prices have no theoretical maximum limit. Naturally, stock prices do not actually increase to infinity, but over time the stock price may continue rising. However, any gains in the underlying stock would be partially offset by losing the premium paid once the put option expires worthless.
In this example, if the stock rose to $70 and the $40 put expired worthless, you would lose the $4 in premium paid, but have $20 in unrealized gains on the stock at that time.
Breakeven: cost basis of underlying stock plus premium paid
In order to breakeven on a married put, the underlying stock price must increase enough to offset the amount of premium paid.
In this example, the stock would need to increase to $54 in order to cover the $4 premium paid.
Your mileage may vary
It's worth noting that the above calculations for max gain, max loss, and breakeven become more complicated if you are not establishing a stock position at the same time.
For instance, if you've held the stock for an extended period of time and have a very low cost basis on the stock, then the max gain, max loss, and breakeven points will differ. Investors will sometimes use protective puts as a way to protect significant gains over time, or may purchase additional puts for continued protection over time as subsequent puts expire.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.