I'm completely new to this stuff but saw a video on this particular topic which seems easy enough in its most basic form.  Here's the scenario though.  What if you buy a protective put with a strike price above the current underlying price.  Take AIG for example, you have the stock at $1 and assume it won't hit $5 within 90 days (reasonable right?) so you buy a protective put for the 100 shares of stock you currently own.  Doesn't that mean you have the option to sell your stock in 90 days for $5?  There's obviously some flaw in my logic otherwise more people would be doing this.  Could someone please help me work out the kink in this strategy?

On a side note, if an options contract is general sold on a 100 share basis, how can I buy a protective put on say 36 shares of underlying?  I understand I can buy the contract and I'll be covered, but then when it comes time to sell I'll have 64 extra options with no way to utilize them?  Please help

konsts said: Take AIG for example, you have the stock at $1 and assume it won't hit $5 within 90 days (reasonable right?) so you buy a protective put for the 100 shares of stock you currently own.  Doesn't that mean you have the option to sell your stock in 90 days for $5?  There's obviously some flaw in my logic otherwise more people would be doing this.  Could someone please help me work out the kink in this strategy?

 

Yes, you will have the right to sell the stock at any time for $5.  Not just in 90 days, but I do believe US options are exercisable able at any time until the end of the expiration day.  They always expire on the third Friday of the month barring some holiday interfering.

The problem with your concept is that if the stock is trading at $1 and the strike price on the put is $5, then the puts are going to cost you something like $4.50.  That is $450 per option because of course each option covers 100 shares.

If the stock stays at $1 until expiration, you will have lost $450.  If you decide to exercise the put, you would sell your 100 shares for $5 each.  That would give you $500.  It cost you $450 to do this.  $500-$450...  There's $50 to get there, but of course you have to factor in what you paid for the stocks.  If you initiate this trade while sitting at $1 per share, you could just sell your shares and get $100, instead of $50.  Not to mention the commissions you'll save.

Essentially, what you haven't factored in is that options are not priced favorably.  With options you have to pay up to get them.  This makes immediately exercising them always unprofitable.