Cl,apter 17: Put Buying in Conjunction with Common Stock Ownership 273 
The long-term holder who strongly feels that his stock will drop should proba­
bly sell that stock. However, his cost basis may make the capital gains tax on the sale 
prohibitive. He also may not be entirely sure that the stock will decline - and may 
want to continue to hold the stock in case it does go up. In either case, the purchase 
of a put will limit the stockholder's downside risk while still allowing room for upside 
appreciation. A large number of individual and institutional investors have holdings 
that they might find difficult to sell for one reason or another. The purchase of a low­
cost put can often reduce the negative effects of a bear market on their holdings. 
The second general class of put buyers for protection includes the investor who 
is establishing a position in the stock. He might want to buy a put at the same time 
that he buys the stock, thereby creating a position with profitability as depicted in the 
previous profit graph. He immediately starts out with a position that has limited 
downside risk with large potential profits if the stock moves up. In this way, he can 
feel free to hold the stock during the life of the put without worrying about when to 
sell it if it should experience a temporary setback. Some fairly aggressive stock traders 
use this technique because it eliminates the necessity of having to place a stop loss 
order on the stock. It is often frustrating to see a stock fall and touch off one's stop 
loss limit order, only to subsequently rise in price.' The stock owner who has a put for 
protection need not overreact to a downward move. He can afford to sit back and 
wait during the life of the put, since he has built-in protection. 
WHICH PUT TO BUY 
The selection of which put the stock owner purchases will determine how much of 
his profit potential he is giving up and how much risk he is limiting. An out-of-the­
money put will cost very little. Therefore, it will be less of a hindrance on profit 
potential if the underlying stock rises in price. Unfortunately, the put's protective fea­
ture is small until the stock falls to the striking price of the put. Therefore, the pur­
chase of the out-ofthe-rrwney put will not provide as much downside protection as 
an at- or in-the-money put would. The purchase of a deeply out-of-the-money put as 
protection is more like "disaster insurance": It will prevent a stock owner from expe­
riencing a disaster in terms of a downside loss during the life of the put, but will not 
provide much protection in the case of a limited stock decline. 
Example: XYZ is at 40 and the October 35 put is selling for ½. The purchase of this 
put as protection for the common stock would not reduce upside potential much at 
all, only by ½ point. However, the stock owner could lose 5½ points if XYZ fell to 35 
or below. That is his maximum possible loss, for if XYZ were below 35 at October expi­
ration, he could exercise his put to sell the stock at 35, losing 5 points on the stock, and 
he would have paid ½ point for the put, bringing his total loss to 5½ points.