Investments, tenth edition

 Table 20.1 

 Value of a protective 

put portfolio at option 

expiration 

S

T

 " X

S

T

 + X

 Stock

S

T

S

T

1

 Put    

X 2 S

T

0

5

  TOTAL

X

S

T

S

T

S

T

S

T

Payoff of Stock

Payoff of Option

Payoff of

Protective Put

Payoff

Profit

X

X

X

X

X 

− (S

0

 

+ P)

A: Stock

+ B: Put

= C: Protective Put

 Figure 20.6 

Value of a protective put position at option expiration  

bod61671_ch20_678-721.indd   690

bod61671_ch20_678-721.indd   690

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  C H A P T E R  

2 0

  Options Markets: Introduction

691

 Figure 20.7  compares the profits for the two 

strategies. The profit on the stock is zero 

if the stock price remains unchanged and 

S

T 

   5   S  

0

 . It rises or falls by $1 for every dollar 

swing in the ultimate stock price. The profit 

on the protective put is negative and equal 

to the cost of the put if  S  

 T 

  is below  S  

0

 .  The 

profit on the protective put increases one for 

one with increases in the stock price once  S  

 T 

  

exceeds  S  

0

 .  

  Figure  20.7  makes it clear that the pro-

tective put offers some insurance against 

stock price declines in that it limits losses. 

Therefore, protective put strategies provide 

a form of  portfolio insurance.  The cost of 

the protection is that, in the case of stock 

price increases, your profit is reduced by 

the cost of the put, which turned out to be 

unneeded. 

 

This example also shows that despite 

the common perception that derivatives 

mean risk, derivative securities can be used 

effectively for  

risk management. 

 In fact, 

such risk management is becoming accepted as part of the fiduciary responsibility of 

financial managers. Indeed, in one often-cited court case,  Brane  v.  Roth,  a company’s 

board of directors was successfully sued for failing to use derivatives to hedge the 

price risk of grain held in storage. Such hedging might have been accomplished using 

protective puts. 

 The claim that derivatives are best viewed as risk management tools may seem surpris-

ing in light of the credit crisis of the last few years. The crisis was immediately precipi-

tated when the highly risky positions that many financial institutions had established in 

credit derivatives blew up 2007–2008, resulting in large losses and government bailouts. 

Still, the same characteristics that make derivatives potent tools to increase risk also make 

them highly effective in managing risk, at least when used properly. Derivatives have aptly 

been compared to power tools: very useful in skilled hands, but also very dangerous when 

not handled with care. The nearby box makes the case for derivatives as central to risk 

management.