Part II of Day Traders and Swing Traders and Options? Maybe!
Before every protective put trade it is possible to calculate your anticipated maximum loss. Use the formula: (stock price minus strike price) plus option price. For example, suppose you will pay $30.00 for your stock, and you want no more than a $3.50 loss on the position. Then you would choose the $27.50 strike put which costs $1.00. Following the formula, you take your stock price ($30.00) and subtract the put's strike price (27.50) which leaves you $2.50. To this $2.50 loss, you then add the amount you spent on the option ($1.00), which gives you a combined, maximum loss of $3.50 for this position. You can set your loss limit by the strike price of the put you buy and the cost of the put. This formula will work every time. Remember, stock loss, (stock price paid - strike price), plus option cost (option price) equals maximum potential position loss.
The protective put strategy, when used correctly, will allow investors to take advantage of the same opportunities that could provide large potential gains, but without being exposed to the extreme risks the position could potentially present. In these scenarios, the protective put strategy deserves consideration.
For example, a stock in the process of a steep decline would be a good opportunity to implement a protective put, when trying to pick a bottom. Quite often, stocks experience bad news or break down through a technical support level and trade down to seek a new, lower trading range.
Everyone wants to find the bottom to buy and go long, catching the technical rebound, or to start accumulating the stock at lower levels for the longer term.
There is a potential for a very big reward if you pick the "right" bottom. However, with the big potential gain comes the big potential loss that is common in these types of risk/reward scenarios. Here is a perfect opportunity to employ the protective put strategy! It will provide protection against substantial loss, while allowing room for potential gains if the stock should bounce.
Remember, the protective put allows for a large potential upside with a limited, fixed downside risk. If you feel that the stock has bottomed out and is starting to consolidate, you purchase the stock and then purchase the put at the same time as insurance against further decline in the stock.
If you are right, and the stock runs back up, the stock profit will well exceed the price paid for the put. Once the stock trades back up, consolidates, and develops its new trading range, the need for the protective put is over. At this time, if you still like the stock and want to hold on to the long position, you could always start selling calls against it.
Use the formula for maximum loss discussed earlier. Calculate the loss in the stock and the amount you paid for the put and add them together for your maximum loss in this position. The protective put has limited your loss.
Maximum Loss = (Stock Price - Strike Price) + Option Price
This protection will save you enough money when you pick a false (wrong) bottom that you may, if you like, try to pick the bottom again at a lower point. The exhaustion scenario, as described here, is a perfect opportunity to apply the protective put strategy.
As seen with the exhaustion example, the protective put strategy is best used in situations where the stock has a potential for an aggressive upside move and the chance of a big downside move.
Another potential opportunity for using the protective put is in combination with Technical Analysis. Technical Analysis is the study of charts, indicators oscillators, etc. Charting has proven to be reasonably accurate in forecasting future stock movements.
Stocks travel in cycles that can and do form repetitious patterns. These patterns are predictable and detectable by the use of any number of charts, indicators and oscillators.
Although there are many, many forms and styles of technical analysis, they all have several similarities. The one we want to focus on is the technical "break-out." A break-out is described as a movement of the stock where its price trades quickly through and beyond an obvious "technical resistance" or resistance point.
For a bullish breakout, this level is at the very top of its present trading range. Once through that level, the stock is considered to have "broken out" of its trading range and will now often trade higher, and establish a new higher trading range.
The "break-out" is normally a rapid, large upward movement that usually offers an outstanding potential return if identified properly and acted upon in a timely fashion. However, if the break-out fails, the stock could trade back down to the bottom of the previous trading range.
If this were to happen, you would have incurred a large loss because you would have bought at the upper end of the previous trading range. As you can see the "break-out" scenario is an opportunity that has large potential rewards but can on occasion, have a large downside risk.
However, if you were to apply a protective put strategy with the stock purchase, you can drastically limit your downside exposure. For instance, say you were to buy the 65 strike put for $2.00. If the stock trades up to $75.00, you would make $9.00 if done naked but only make $7.00 if done with the protective put.
This difference is the cost of the put. This $2.00 investment is more than worth it should the stock go down. If the break-out turns out to be a "false" break-out and the stock reverses and trades down, your 65 put will allow you to sell your stock out at $65.00 minus the $2.00 you paid for the put. This limits your loss to $3.00 instead of a potential $8.00 loss. This is a much better risk/reward scenario.
Most professional traders, including day traders and swing traders can reap huge rewards for the protective put strategy. The reason is in how most traders attain profits and losses. Normally, successful traders make a little money on a consistent basis. They make a little bit day in and day out. But when it comes to losses, they lose in large chunks. They spend a month building up profits only to lose that money in one day usually in one stock. If a trader could figure out how to avoid even a handful of these large losses, his or her profitability would soar. My answer is to start using the protective put when buying on breakouts and when bottom fishing.
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