Question

Which one of the following strategies allows you to minimize downside risk with the cost of the put option?

O covered call
O protective
O put straddle
O spread collar

Answer 1

The protective put strategy allows you to minimize downside risk with the cost of the put option.

Step-by-step explanation:

The strategy that allows you to minimize downside risk with the cost of the put option is the protective put strategy.

In a protective put, you own a stock and buy a put option on that stock. The put option gives you the right to sell the stock at a predetermined price, known as the strike price, within a specified time frame. This strategy protects you from downside risk because if the stock price drops, you can exercise the put option and sell the stock at the higher strike price, limiting your losses.

For example, let's say you own 100 shares of a stock currently trading at $50 per share. You buy a put option with a strike price of $45 expiring in one month. If the stock price drops to $40, you can exercise the put option and sell the stock at $45, protecting yourself from further losses.

With a protective put, if the stock price falls, the investor can exercise the put option, selling the stock at the strike price, thereby limiting their losses. The cost of the put option is the maximum potential loss beyond the stock's decline to the strike price. This strategy is advantageous because it combines the upside potential of holding the stock with the downside protection of the put.