Part 2: Key Point In Protective Put Strategy & Value Options

Another potential opportunity for using the protective put with value options is in combination with Technical Analysis. Technical Analysis is the study of charts, indicators oscillators, etc. Charting has proven to be more than reasonably accurate in forecasting the movements of future value options.

Value options 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 value options where their 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 value options are 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 value options 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 for the value options. 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.

Therefore, this is an excellent scenario for application of the protective put strategy.

For example, XYZ is presently at the top of a trading range with the upper end of the range being $66.00 and the bottom end of the range being $58.00. When the chart, indicator, or oscillator you are using identifies the break-out of the value options (when it trades through $66.00), you would buy the value options immediately.

The risk of the value options not following through with its breakout is not large but it does happen. The value options could trade back down to $58.00 which is the bottom of the trading range. If you had bought the value options naked above $66.00, you would realize a minimum $8.00 loss.

However, if you were to apply a protective put strategy with the value options purchase, you can drastically limit your downside exposure. For instance, say you were to buy the 65 strike put for $2.00. If the value options 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 value options go down. If the break-out turns out to be a “false” break-out and the value options reverse and trades down, your 65 put will allow you to sell your value options 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.