EXHIBIT 1.7 SPY protective put.
The solid kinked line is the protective put (put and stock), and the thin
dotted line is the outright position in SPY alone, without the put. The most
Kathleen stands to lose with the protective put is $3.65 per share. SPY can
decline from $140.35 to $139, creating a loss of $1.35, plus the $2.30
premium spent on the put. If the stock does not fall and the insuring put
hence does not come into play, the cost of the put must be recouped to
justify its expense. The break-even point is $142.65.
This position implies that Kathleen is still bullish on the Spiders. When
traders believe a stock or ETF is going to decline, they sell the shares.
Instead, Kathleen sacrifices 1.6 percent of her investment up front by
purchasing the put for $2.30. She defers the sale of SPY until the period of
perceived risk ends. Her motivation is not to sell the ETF; it is to hedge
volatility.
Once the anticipated volatility is no longer a concern, Kathleen has a
choice to make. She can let the option run its course, holding it to
expiration, at which point it will either expire or be exercised; or she can
sell the option before expiration. If the option is out-of-the-money, it may
have residual time value prior to expiration that can be recouped. If it is in-
the-money, it will have intrinsic value and maybe time value as well. In this
situation, Kathleen can look at this spread as two trades—one that has