What is a protective put and how do i use it?

Question

how do i use it when buying stocks?

also, what is a "covered call", a "straddle" and a "bullish spread"? how do i apply all these in the stock market. if possible try to give me an example so i understand it better.

Answer 1

OPM gave you reasonable examples of these different strategies. (There is a typo in the covered call example. He wrote "sell a put" when he meant "sell a call" instead.) He did not, IMHO, give good definitions of what they are.

All of them are examples of "spreads" in which at least one of the positions of the spread is an options position. A spread is two or more positions where at least one of the positions is bullish (expected to increase in value if the stock price moves up) and at least one of the positions is bearish (expected to increase in value if the stock price moves down).

If you are not familiar with options and how they work you might want to spend an hour or so and go through the first three tutorials at

http://www.cboe.com/LearnCenter/Tutorials.aspx

or you are likely to have difficulty understanding these spreads.

(1) Pretective Put

Definition

Buying a protective put involves buying one put contract for every 100 shares of underlying stock already owned or simultaneously purchased. This put guarantees the owner the right, but not the obligation, to sell the shares at the strike price at any time until the option expires, no matter how low the stock declines in value. And just as with other forms of insurance the investor pays a premium for this protection - the premium paid for the put.

http://www.cboe.com/Strategies/EquityOptions/ProtectivePuts/Part1.aspx

(2) Covered Call

Definition

Covered call writing is either the simultaneous purchase of stock and the sale of a call option, or the sale of a call option covered by underlying shares currently held by an investor. Generally, one call option is written for every 100 shares of stock owned. The writer receives cash for selling the call but will be obligated to sell the stock at the call's strike price if assigned, thereby capping further upside stock price participation. In other words, an investor is "paid" for agreeing to sell his holdings at a certain level (the strike price). For this reason the covered call is considered a neutral to moderately bullish strategy. On the downside, limited stock price protection is provided by the premium received from the call's sale.

http://www.cboe.com/Strategies/EquityOptions/CoveredCalls/Part1.aspx

(3) Straddle

A long straddle is the simultaneous purchase of both call and put options with the same expiration date and strike price. A short straddle is the simultaneous sale of both call and put options with the same expiration date and strike price.

For and example of a long straddle see

http://www.cboe.com/Strategies/WeeklyStrategy.aspx?DIR=LCWeeklyStrat&FILE=Oct1607strategy.doc&CreateDate=16.10.2007

(4) Bullish Spread

There are many different kinds of bullish spreads. By definition a bullish spread is any spread that increases in value with an increase in the price of the underlying stock.

Perhaps the most straightforward example of a bullish spread is a bullish vertical call spread. For an example, see

http://www.cboe.com/Strategies/WeeklyStrategy.aspx?DIR=LCWeeklyStrat&FILE=Sept2507strategy.doc&CreateDate=25.09.2007

Answer 2

Example of protective put:

You own IBM selling at $100, you buy a put for IBM, strike price 90, for 5 limiting your loss to $85 per share and guaranteeing a loss of $5.

Example of a covered call:

You own IBM at $100 and you believe it is over valued at $120 so you sell a put for the same number of shares at $2 so if the stock hits 120, where you would sell anyway, you get 122 instead and 2 no matter what reducing your real position to 98 in cost.

Example of a straddle

You own no stock. You buy 1 call option for IBM, strike 100, at 100 for 15, you buy 1 put option for IBM, strike 100, at 100 for 15. You make money if the stock collapses or explodes. The stock must move more than 30 to make any money. You can also be the seller of the two options instead.

Example of a bullish spread:

You buy a call option of IBM at 100 for a short time, say one month for 5, you sell a call option at 115 expiring at the same time at 2, costing you 3. If the stock expires at least at 103 you make a profit, otherwise you lose up to 3 dollars per share and can make no more than 12 per share.

The only one that is really likely to be profitable for the average trader is the covered call. It is likely to happen, but you make spare money on your existing investment. It tends to give a steady income on top of the investment.