A floor is an options insurance strategy where you simultaneously have a long open position on a stock and a long put for the same underlying asset. Adding a long put to your open position means that you are obligated to sell your stock at the strike price. The long put ensure that you can sell your stocks at a defined price. Since you already have the stock in your open position, you will gain the difference from the long stock and long put. The combination of those two products creates a payoff that is like a long call. However, the profit is not the same since you spent more on a floor versus a call option.
What are its components?
A floor has two components:
- Long Stock
- Long Put
When and why should I have a floor?
You should have a floor if you are bullish on a stock and wish to have an extra protection in case the price of the stock goes down. By adding a long put to your long position, you are willing to reduce your profit should the stock price increase to create a ‘floor’, which is the lowest profit you can attain if the price is lower than the strike price. Creating a floor guarantees a minimum stock price for which you can close your current position.
What is the payoff and profit graph?
What is the break-even point?
The break-even point of a floor can be defined by finding the stock price where the floor generates a zero-dollar profit. By adding the long stock and long put together and equating it to zero, you should solve for ST.