Question

You’ve decided that stock XYZ is a potentially exciting company to invest in because of new technology they have under development. You are eager to invest, but recognize that this is a high risk investment because of the high volatility in the price of the stock, and the relatively high risk of a large price decrease if the technology develops slowly or does not succeed.

Explain the relative advantages and disadvantages of a stop-loss order versus buying a put option to protect your investment when buying the stock.

Answer 1

Solution:

The advantages and disadvantages of stop loss vs buying a put option

Advantage of stop loss order

1) This will limit the loss when the price of the stock falls. The share will be sold at given price so that further loss can be avoided.

Disadvantage of Stop loss order

1) The loss will be there when share price fall and when share prices rises again then the investor will lose

Advantage of put option

1) When share price falls then the premium of put will rise and the investor can recoup the loss due to share price by rise in premium

Disadvantage of put option

1) Investor needs to pay premium for the put option and if share prices rises after the purchase then put option becomes worthless