Stop-Loss Versus Protective Put on a Concentrated Position
A portfolio manager holds a 9% position in a mid-cap industrial stock, now $68, with a cost basis of $42. The stock's 20-day ATR is $2.10; 30-day implied volatility is 38%; beta to the benchmark is 1.3; correlation is 0.65. Earnings are due in 10 days. The portfolio's monthly risk budget is 1.5%, and the fund has a hard stop policy at 2 ATR below the current price, roughly $61. A 45-day 65-strike put costs $3.20. The stock is liquid but borrow is 4%. The PM believes the long-term trend is intact but wants to protect gains and avoid a gap through the stop. The risk committee asks whether to use the stop, buy the put, trim the position, or combine tools, and how to size the remaining exposure.
1. Compare the hard stop, the protective put, and a partial trim on risk, cost, and gap protection. Use the numbers provided.
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The stop at $61 is about $7 below the $68 price, or roughly 3.3 ATR (2.10), not 2 ATR; a 2 ATR stop would be near $63.80. A stop limits normal losses but does not protect against an earnings gap through $61; the realized loss could be much larger. The 65-strike put costs $3.20, or 4.7% of the stock price, and defines a floor at $65 minus the premium, i.e., $61.80, before transaction costs. That is close to the stop level but with gap protection. A partial trim, say selling 3% of the 9% position, raises cash and reduces the position to 6%; it cuts both upside and downside and has no premium cost, but it does not cap the remaining 6% tail. On a portfolio basis, a 10% gap in a 9% position is a 0.9% portfolio loss, which is 60% of the 1.5% monthly risk budget; in a 6% position it is 0.6%, or 40% of the budget.
2. Size the remaining exposure using the monthly risk budget and gap risk. What combination would you recommend?
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Start from the risk budget. If the fund is willing to lose 1.5% of assets on this position in a severe gap, and a realistic earnings gap is 15-20%, then a 9% position is too large: 9% x 18% = 1.62%, already above the budget before considering beta and correlation. A 6-7% position gives 1.08-1.26% at an 18% gap, leaving room for other risks. Recommendation: trim the position to 6.5%, buy the 65-strike put on the remaining shares, and set a mental stop at $61 as a secondary exit. The put premium of 4.7% on 6.5% is about 0.31% of the portfolio, a known cost. The combined position caps the gap loss near the put floor while reducing concentration. If the PM is confident in the long-term trend, use a collar (buy 65 put, sell 75 call) to reduce premium, but accept capped upside.
3. What behavioral and implementation issues should the committee consider before choosing among these tools?
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Behavioral issues: the PM's cost basis of $42 creates a large gain, so loss aversion and anchoring may encourage inaction; a hard stop can be moved or overridden during a gap, which is why the put is more credible. The committee should pre-commit to rules before earnings. Implementation: check option liquidity and bid-ask spread; a $3.20 put may be quoted wide. The put has a 45-day life, so it covers earnings but not a later decline; decide whether to roll it. The stop may trigger on intraday noise; use a closing stop. Borrow cost of 4% matters only for shorting, not for this long position, unless the fund uses a collar. Tax: trimming realizes gains; the put premium is a cost but may defer gains. Finally, the risk budget is monthly, so a gap loss in one month can force unrelated de-risking; a put converts an uncertain tail into a known premium.