Portfolio Protection using Options

Portfolio Protection using Options
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Portfolio Protection using Options
The term option could be elucidated as a contract in which the contract holder owns a right to buy or sell a security at a specified price in future , but is not obligated to do so (Mullaney, 2009). Therefore, options are an exceptionally flexible tool used by investors to boost, protect, and diversify their portfolios. They can also make investors lose money. Simply put, reckless investors who use options can lose up to eighty percent of their money while smart investors who use options use the tool to reduce risk. It follows that investors should understand options because knowledge on options will help them to reduce risks when trading in securities. As a result, this paper discusses protective puts and collaring as strategies an investor could use to protect portfolios from declining in value. It is critical that the discussion also includes a numerical example to illustrate the possible actions for an investor.
To begin with, it is vital to highlight the meaning of at the money, in the money, and out of the money because the terms will be used later in the discussion. The term in the money refers to a put option whose price of the market is below the agreed price (in the contract), or a call option whose price of the market is above the agreed price. In simple terms, an option is in the money if exercising the option gives the investor positive returns. Analogously, an option is at the money if the price of the market is similar to the agreed price (in the contract) regardless of whether it is a call or a put option. Ultimately, an option is said to be out of the money if the agreed price of a put option is lower than the price in the market or if the agreed price of a call option is higher than the price in the market (Baker and Filbeck, 2013). Therefore, an investor who chooses to exercise an option that is out of the money receives negative returns.
The first strategy an investor could use to protect the portfolio from declining is to use protective puts. As evidence, Mullaney (2009) argues that protective puts provide a downside protection against a possible decline in the value of a portfolio. The following numerical illustration demonstrates how an investor can use a protective put to safeguard a portfolio against loss. Consider the fact that an investor owns 100 shares from Mattel incorporation and that each share costs $ 22. Also, consider the fact that the investor anticipates that the value of the stock can decline in the next three months. In order, to protect the portfolio against extreme loss, the investor purchases a twenty-one dollar put option for $ 2. This implies the investor will incur a cost of $ 200 dollars to purchase the option. If the stock moves be...