Strategy Number 7 – Long “Covered” Put

Market dATA
DJ Index100 points
Prices
Base asset price$10,000

Put 100$1,000
Strategy name:

Long “Covered” Put

 

Recommended use of strategy

Expectation of an increase in DJ Index, but with concern that the index could fall.

 

Strategy components

  1. Purchasing (Long) the base asset – the DJ Index or a mutual fund investing in the DJ shares (see page 9).
  2. Purchasing a Long Put option at a strike price equal to the DJ Index.

 

Example: Purchase (Long) the base asset at a price of $10,000 and purchase a Long Put 100 option for $1,000. The strategy is known as a Short Futures Contract since this combination creates an obligation (contract) to sell the DJ Index at the exercise date at its current price (100 points – $10,000).

 

Expenses / Income from building the strategy

Expenditure of $11,000.

 

Strategy graph:

graph

Auxiliary table for building the profit line  

 

 

DJ Index
(Horizontal axis)
(Fixed expenses)/ fixed incomeVariable expenses
(Put contribution)
Base Asset contributionTotal profit / (loss) 
(Vertical axis)
2+3+4
12345
60$11,000$4,000$6,000($1,000)
70$11,000$3,000$7,000($1,000)
80$11,000$2,000$8,000($1,000)
90$11,000$1,000$9,000($1,000)
100$11,000$10,000($1,000)
110$11,000$11,000$0
120$11,000$12,000$1,000
130$11,000$13,000$2,000
140$11,000$14,000$3,000
150$11,000$15,000$4,000          

Strategy analysis:

Source of profit        

The profit arises from the investment in the mutual fund. The profit increases as the index goes up.

 

Source of loss           

Cost of building the strategy – $11,000. However when the DJ Index goes down, we lose on the mutual fund investment but are fully compensated by the Put option.

 

Break-even point     

This occurs at index 110.

 

Comment                  

This strategy is a form of purchasing “insurance” against the risk of a fall in the value of the DJ Index shares basket.