Protective Put Hedging and Effective Cost Basis
An investor owns 100 shares of TechCorp purchased at $80. Concerned about an upcoming earnings announcement, the investor buys 1 TechCorp Oct 75 Put at $4. What is the investor's breakeven stock price, and what is the maximum loss?
Protective put breakeven = Stock Cost + Put Premium ($80 + $4 = $84). Max Loss = Stock Cost + Put Premium - Put Strike = $80 + $4 - $75 = $9.00 ($900).
Complete Analysis & Legal Rationale
Buying a put acts as an insurance policy. Total cost basis becomes Stock Cost ($80) + Insurance Premium ($4) = $84 breakeven. If TechCorp crashes, the investor exercises the put to sell shares at $75. Loss = $84 breakeven - $75 strike = $9 per share ($900 total).
Mathematical Step-by-Step Derivation
- Step 1: Breakeven = Stock Purchase Price ($80.00) + Put Premium ($4.00) = $84.00.
- Step 2: Worst-Case Exercise Floor = $75.00 Put Strike Price.
- Step 3: Maximum Loss = Total Investment ($84.00) - Guaranteed Floor ($75.00) = $9.00 per share ($900).
- Stock Purchase-$80.00
- Put Premium Paid-$4.00
- Put Floor on Exercise+$75.00 guaranteed
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
Correctly adds insurance premium to cost ($84) and determines max loss between $84 and $75 floor ($900).
Subtracts put premium from stock cost, confusing a protective put with a covered call.
Only counts the stock loss ($80 - $75 = $500) and forgets to include the $400 premium paid.
Assumes stock drops to zero with no protection, ignoring the put exercise right.
Official Standard: Permits protective puts to cap capital risk on underlying equity.