On 7 January 2011, an investor owns 1,000 BHP shares. As indicated in Table 1.2, the share price is $44.60 and an April put option with a strike price of $44 costs $1.61. The investor is comparing two alternatives to limit downside risk. The first involves buying one April put option contract with a strike price of $44. The second involves instructing a broker to sell the 1,000 shares as soon as BHPs price reaches $44. Discuss the advantages and disadvantages of the two strategies.
The second alternative involves what is known as a stop or stop-loss order. It costs nothing and ensures that $44,000, or close to $44,000, is realised for the holding in the event the stock price ever falls to $44. The put option contract costs $1,610 and guarantees that the holding can be sold for $44,000 any time up to April. If the stock price falls marginally below $44 and then rises the option will not be exercised, but the stop-loss order will lead to the holding being liquidated. There are some circumstances where the put option alternative leads to a better outcome and some circumstances where the stop-loss order leads to a better outcome. If the stock price ends up below $44, the stop-loss order alternative leads to a better outcome because the cost of the option is avoided. If the stock price falls to $40 in March and then rises to $45 by April, the put option alternative leads to a better outcome. The investor is paying $1,610 for the chance to benefit from this second type of outcome.