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250 •   TheIntelligentOptionInvestor
The graphic conventions are a little different, but both diagrams show
the acceptance of a narrow band of downside exposure offset by a bound-
less gain of upside exposure. The area below the protective puts strike price
shows that economic exposure has been neutralized, and the area below
the ITM call shows no economic exposure. The pictures are slightly differ-
ent, but the economic impact is the same.
The objective of a protective put is obvious—allow yourself the
economic benefits from gaining upside exposure while shielding yourself
from the economic harm of accepting downside exposure. The problem is
that this protection comes at a price. I will provide more infromation about
this in the next section.
Execution
Everyone understands the concept of protective puts—its just like the
home insurance you buy every year to insure your property against dam-
age. If you buy an OTM protective put (lets say one struck at 90 percent of
the current market price of the stock), the exposed amount from the stock
price down to the put strike can be thought of as your “deductible” on your
home insurance policy. The premium you pay for your put option can be
thought of as the “premium” you pay on your home insurance policy.
Okay—lets go shopping for stock insurance. Apple (AAPL) is trad-
ing for $452.53 today, so Ill price both ATM and OTM put insurance for
these shares with an expiration of 261 days in the future. Ill also annualize
that rate.
Strike ($) “Deductible” ($) “Premium” ($)
Premium as
Percent of
Stock Price
Annualized
Premium (%)
450 2.53 40.95 9.1 12.9
405 47.53 20.70 4.6 6.5
360 92.53 8.80 1.9 2.7
Now, given these rates and assuming that you are insuring a $500,000
house, the following table shows what equivalent deductibles, annual
premiums, and total liability to a home owner would be for deductibles
equivalent to the strike prices Ive picked for Apple: