What is a Protective Put?
A protective put involves buying a put option on a stock that you already own. A put option gives you the right to sell the stock at a specified strike price within a given time frame. By purchasing the put, you are essentially "insuring" your stock against a significant price decline.
Here's how it works:
You own the stock: You hold shares of a company.
You buy a put option: You buy a put option on the same stock, usually at or below the current market price, which gives you the right to sell the stock at the strike price.
By using this strategy, you can protect yourself from large declines in the stock’s price. If the stock price falls below the strike price, the put option increases in value, offsetting some or all of your losses.
How Does a Protective Put Work?
Let’s look at an example to understand how a protective put works:
Step 1: You own 100 shares of ABC Corp., which is currently trading at $50 per share.
Step 2: You buy a put option with a strike price of $45, expiring in 30 days, and pay a premium of $2 per share for the option.
Step 3: There are two possible outcomes:
Stock Price Falls Below Strike Price: If the stock price drops below $45, the put option increases in value. For example, if the stock falls to $40, your put option allows you to sell the stock for $45, limiting your losses to $7 per share ($50 - $45) plus the $2 premium for the put option.
Stock Price Stays Above Strike Price: If the stock stays above $45, the put option expires worthless. In this case, you lose the $2 premium, but you still own the stock, and you continue to participate in any price appreciation.
Benefits of a Protective Put
Downside Protection: The primary benefit of a protective put is that it provides downside protection. If the stock price falls significantly, the put option allows you to sell the stock at the strike price, limiting your losses.
Unlimited Upside Potential: Unlike a covered call, a protective put does not limit your upside potential. If the stock price rises, you can still participate fully in the gains.
Hedge Against Market Volatility: If you’re concerned about a market downturn or specific risks related to your stock holdings, a protective put can act as insurance, helping to manage volatility.
Risks of a Protective Put
Cost of the Put: The main disadvantage of the protective put is the cost of the option. Premiums can be expensive, especially for stocks that are volatile or when the market is experiencing heightened uncertainty. If the stock price does not fall below the strike price, you lose the premium you paid for the put.
Opportunity Cost: If you hold the put for an extended period, the option's premium might erode due to time decay (Theta), which could reduce the overall effectiveness of the strategy.
When to Use a Protective Put
A protective put is best used when you own a stock and want to protect yourself from a potential downside risk, especially if you anticipate short-term volatility or if you want to protect gains made from a strong rally. This option strategy is commonly used by long-term investors who want to continue holding their stock positions but want to guard against significant losses in the near term.