Options course · Lesson 7 of 10
Protection costs money, or it costs upside.
A put sets a floor under a stock that you own. You pay for the floor with cash. With a collar, you pay with part of your upside.
The protective put
You own 100 shares at $100. You buy one 95 put for $241. If the stock falls below $95, the put gains $1 for each $1 that the stock loses.
Your largest loss is $741: $500 from the stock down to $95, plus the premium. Without the put, the loss can be $10,000. Your gain has no limit, but the stock must rise to $102.41 before you break even.
The put costs 2.4% of the stock for 90 days. If you buy the same put four times a year at the same price, the cost is about 9.8% a year. That is the price of a floor.
The collar
A collar adds a short call to the protective put. You sell one 110 call for $189, and it pays for most of the put. The net cost is $52.
Your largest loss is now $552, and your largest gain is $948. You give up all gains above $110. So the collar costs upside instead of money.
| Stock at expiration | Stock alone | Protective put (95) | Collar (95 and 110) |
|---|---|---|---|
| $70 | -$3,000 | -$741 | -$552 |
| $80 | -$2,000 | -$741 | -$552 |
| $90 | -$1,000 | -$741 | -$552 |
| $95 | -$500 | -$741 | -$552 |
| $100 | $0 | -$241 | -$52 |
| $105 | +$500 | +$259 | +$448 |
| $110 | +$1,000 | +$759 | +$948 |
| $120 | +$2,000 | +$1,759 | +$948 |
| $130 | +$3,000 | +$2,759 | +$948 |
The strike sets the deductible
A lower strike costs less, but you take a larger loss before the put pays. The 90 put costs $112 and pays below $90. The 95 put costs $241 and pays below $95. It works like the deductible on an insurance policy.
Key points
- A put sets a floor under a stock that you own.
- You pay for the floor in cash, or in upside with a collar.
- A lower strike is cheaper because you keep more of the loss.
Sources
- Fischer Black and Myron Scholes, The Pricing of Options and Corporate Liabilities, Journal of Political Economy, 1973, for the model that gives every price in this course.