Let’s take this off for a second. You can see if the stock rises by $, to $20, you make a $2000 profit. If you add the insurance, your profit is only $1518. It does limit your upside potential, but not dramatically. When this continues to rise, you make unlimited profits. Basically, what you’re doing is providing insurance for your stock.
Think about it, just for a second. You have an investment here, of $18 a share, times 1000 shares. That’s an $18,000 investment. If you were to use that $18,000 in the marketplace to buy anything else – let’s say, for example, a car. If you took that $18,000 in cash and went and bought a car, wouldn’t it make sense to buy insurance on that car?
In other words, if you got into an accident with that car that cost you $18,000, your loss would be total, if you didn’t have any insurance. The cost of the insurance, even though you may not use it, certainly would pay off if the stock declined, or the car got into an accident.
The amount of insurance that you’re going to pay is based on the value of the car, your driving record, and some other factors. In a stock, the only thing that you would be able to determine is actually how much insurance you want. In this case, we’re covering the 1000 shares of stock with an equivalent of 10 contracts, or 1000 shares protection of the stock, with a put option. A put option will increase in price as the stock moves lower.
We could have selected other contracts. We could have selected the June contract, for example. The June contracts don’t trade the 17.50 put. However, we could select the $18 put, which is the current price of the stock. That would give us even more protection.
For example, let’s bring this up. We’ll analyze that as a duplicate trade, and we’ll take the July one off, just for a second. You can see, as we run our cursor over here, our maximum loss on this particular position, is only $410. That’s with the $18 put for the June expiration.
With the July expiration, we have a maximum loss of $1,110. Why the difference? We’re using the 17.50 strike instead of the 18 strike. Also, the 18.50 strike is a little bit more expensive. It’s 60 cents, instead of 40 cents. If the June option at $18 provided us with more protection, and it was cheaper, why not use that?
The reason is that you’re paying for only 8 days of protection. There are only 8 days left until the June expiration of these options. Once these options expire in 8 days, we have no more protection left.
We’re going to eliminate that as a potential for protecting our stock. We don’t want to pay 40 cents for 8 days of protection. Instead, we would use the July options, which would give us 36 days of protection. That’s quite a bit of a difference, even though we’re paying 20 cents more for that option.
Now, the July options do not have an $18 strike price. They have a $17.50, and they have a $19 strike price. Our options are limited. We can’t go to the $18 strike price. We can only go to one of the prices that are available in the option chain. If we go back to our Analyze tab, and we decide that, “We’re going to buy 1000 shares of Starbucks stock, at $18 a share,” what are our other options for protecting our position?
We could buy the same number of options at the July 17.5 put options, at 60 cents. Or we could buy something a little bit more conservative. Let’s say this scenario, based on our Analyze tab, is not acceptable to us. We’re not willing to lose $1,110, if the shares of Starbucks declined. Yes, we like the upside potential, but we’re not willing to take the risk of $1000, if the stocks will decline, before the expiration of the July options.
In order to protect our stock at a more conservative rate, we would have to raise the strike price. In other words, we would have to go a little bit deeper or closer to the money. Remember, in the July options, there was not an $18 strike price. So we cannot use that one.
The next strike price that we would have to go to is the $19 option. The $19 option would cost us $1.42. That’s quite a bit more cost than protection. In fact, if we go back and take a look at this, if we go back to the $19 strike price for the July options, it’s going to cost us $1.42. Multiplied by 10 contracts, that’s $1420.
That’s quite a bit of insurance to pay, even though it is 36 days out. What does that do to our Analysis tab? In our analysis now, our maximum loss on this position is only $440. Our upside potential still remains relatively intact. We don’t make as much on the upside potential.
Without the insurance, remember that we make about $2000 for a $2 move in the stock. We also lose $2000. With our insurance, even though it costs us $1400, we still have $1000 of upside potential if it moves up $2. Our maximum loss at $2 down is only $410.
It does limit our risk quite a bit. Our maximum risk on the entire trade, and it doesn’t matter how low the stock goes – let’s say we wake up tomorrow morning, and Starbucks is trading at $5 a share. Our maximum loss is still only $440.
The amount of risk that you take in a stock is really dependent upon how much risk you want to take. Let’s take a look at another scenario. Let’s say that you’re very aggressive, and you think that there is no way that Starbucks is going to drop back down to – it was as low as $15.50. You agree with the idea that having insurance on your stock in the form of purchasing a put option is a good idea, but you’re very aggressive on the stock, and you think that it’s not going to go down to $15.
We’ll look at the $15 July options. We only want catastrophic insurance on our stock. In other words, if it opens up $5 lower, and it’s trading at around $14, or $12.50, then our $15 put options should be worth at least $1, $1.50.
What does that do to our profit and risk and reward analysis? If we drop down, and we go down to the $15 strike price, it’s only going to cost us 10 cents. That’s not a bad deal. 10 cents of insurance would cost us, on 10 contracts – which is equal to 1000 shares of stock – it would only cost us $115. That’s a relatively inexpensive insurance policy.
If we look at our Analysis tab, our maximum risk has now jumped from $440, to $3110. That’s even worse than the $17.5 strike price that we had analyzed in the beginning.
Yes, our upside potential is intact. We could gain $1900, which is almost the full amount, even if we didn’t have the insurance. If we took the insurance off, we would have a $1,990 profit, on a $2 move up in the stock. If we added the insurance, our upside potential is only reduced by about $95, or $90.
The upside potential remains intact. However, if we took a look at the downside, if the stock does drop by $2, we’ll lose $1,670.