Protective Put Explained

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protective put

Definition

Use protective put in a sentence

“ It was a protective put and I was glad too because I had been searching for something like that for a long time. ”

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“ The client was concerned about a potential drop in the price of the security so we put in him in a protective put . ”

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“ Investors will often purchase protective put s in order to shield unrealized profits in a given security against significant market moves to the downside. ”

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Protective Put

What Is a Protective Put?

A protective put is a risk-management strategy using options contracts that investors employ to guard against the loss of owning a stock or asset. The hedging strategy involves an investor buying a put option for a fee, called a premium.

Puts by themselves are a bearish strategy where the trader believes the price of the asset will decline in the future. However, a protective put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty.

Protective puts may be placed on stocks, currencies, commodities, and indexes and give some protection to the downside. A protective put acts as an insurance policy by providing downside protection in the event the price of the asset declines.

Key Takeaways

  • A protective put is a risk-management strategy using options contracts that investors employ to guard against a loss in a stock or other asset.
  • For the cost of the premium, protective puts act as an insurance policy by providing downside protection from an asset’s price declines.
  • Protective puts offer unlimited potential for gains since the put buyer also owns shares of the underlying asset.
  • When a protective put covers the entire long position of the underlying, it is called a married put.

How a Protective Put Works

Protective puts are commonly utilized when an investor is long or purchases shares of stock or other assets that they intend to hold in their portfolio. Typically, an investor who owns stock has the risk of taking a loss on the investment if the stock price declines below the purchase price. By purchasing a put option, any losses on the stock are limited or capped.

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The protective put sets a known floor price below which the investor will not continue to lose any added money even as the underlying asset’s price continues to fall.

A put option is a contract that gives the owner the ability to sell a specific amount of the underlying security at a set price before or by a specified date. Unlike futures contracts, the options contract does not obligate the holder to sell the asset and only allows them to sell if they should choose to do so. The set price of the contract is known as the strike price, and the specified date is the expiration date or expiry. One option contract equates to 100 shares of the underlying asset.

Also, just like all things in life, put options are not free. The fee on an option contract is known as the premium. This price has a basis on several factors including the current price of the underlying asset, the time until expiration and the implied volatility (IV)—how likely the price is going to change—of the asset.

Strike Prices and Premiums

A protective put option contract can be bought at any time. Some investors will buy these at the same time and when they purchase the stock. Others may wait and buy the contract at a later date. Whenever they buy the option, the relationship between the price of the underlying asset and the strike price can place the contract into one of three categories—known as the moneyness. These categories include:

  1. At-the-money (ATM) where strike and market are equal
  2. Out-of-the-money (OTM) where the strike is below the market
  3. In-the-money (ITM) where the strike is above the market

Investors looking to hedge losses on a holding primarily focus on the ATM and OTM option offerings.

Should the price of the asset and the strike price be the same, the contract is considered at-the-money (ATM). An at-the-money put option provides an investor with 100% protection until the option expires. Many times, a protective put will be at-the-money if it was bought at the same time the underlying asset is purchased.

An investor can also buy an out-of-the-money (OTM) put option. Out-of-the-money happens when the strike price is below the price of the stock or asset. An OTM put option does not provide 100% protection on the downside but instead caps the losses to the difference between the purchased stock price and the strike price. Investors use out-of-the-money options to lower the cost of the premium since they are willing to take a certain amount of a loss. Also, the further below the market value the strike is, the less the premium will become.

For example, an investor could determine they’re unwilling to take losses beyond a 5% decline in the stock. An investor could buy a put option with a strike price that is 5% lower than the stock price thus creating a worst-case scenario of a 5% loss if the stock declines. Different strike prices and expiration dates are available for options giving investors the ability to tailor the protection—and the premium fee.

Important

A protective put is also known as a married put when the options contracts are matched one-for-one with shares of stock owned.

Potential Scenarios with Protective Puts

A protective put keeps downside losses limited while preserving unlimited potential gains to the upside. However, the strategy involves being long the underlying stock. If the stock keeps rising, the long stock position benefits and the bought put option is not needed and will expire worthlessly. All that will be lost is the premium paid to buy the put option. In this scenario where the original put expired, the investor will buy another protective put, again protecting his holdings.

Protective puts can cover a portion of an investor’s long position or their entire holdings. When the ratio of protective put coverage is equal to the amount of long stock, the strategy is known as a married put.

Married puts are commonly used when investors want to buy a stock and immediately purchase the put to protect the position. However, an investor can buy the protective put option at any time as long as they own the stock.

The maximum loss of a protective put strategy is limited to the cost of buying the underlying stock—along with any commissions—less the strike price of the put option plus the premium and any commissions paid to buy the option.

The strike price of the put option acts as a barrier where losses in the underlying stock stop. The ideal situation in a protective put is for the stock price to increase significantly, as the investor would benefit from the long stock position. In this case, the put option will expire worthlessly, the investor will have paid the premium, but the stock will have increased in value.

For the cost of the premium, protective puts provide downside protection from an asset’s price declines.

Protective puts allow investors to remain long a stock offering the potential for gains.

If an investor buys a put and the stock price rises, the cost of the premium reduces the profits on the trade.

If the stock declines in price and a put has been purchased, the premium adds to the losses on the trade.

Real World Example of a Protective Put

Let’s say an investor purchased 100 shares of General Electric Company (GE) stock for $10 per share. The price of the stock increased to $20 giving the investor $10 per share in unrealized gains—unrealized because it has not been sold yet.

The investor does not want to sell their GE holdings, because the stock might appreciate further. They also do not want to lose the $10 in unrealized gains. The investor can purchase a put option for the stock to protect a portion of the gains for as long as the option contract is in force.

The investor buys a put option with a strike price of $15 for 75 cents, which creates a worst-case scenario of selling the stock for $15 per share. The put option expires in three months. If the stock falls back to $10 or below, the investor gains on the put option from $15 and below on a dollar-for-dollar basis. In short, anywhere below $15, the investor is hedged until the option expires.

The option premium cost is $75 ($0.75 x 100 shares). As a result, the investor has locked in a minimum profit equal to $425 ($15 strike price – $10 purchase price =$5 – $0.75 premium = $4.25 x 100 shares = $425).

To put it another way, if the stock declined back to the $10 price point, unwinding the position would yield a profit of $4.25 per share, because the investor earned $5 in profit—the $15 strike less $10 initial purchase price—minus the 0.75 cents premium.

If the investor didn’t buy the put option, and the stock fell back to $10, there would be no profit. On the other hand, if the investor bought the put and the stock rose to $30 per share, there would be a $20 gain on the trade. The $20 per share gain would pay the investor $2,000 ($30 – $10 initial purchase x 100 shares = $2000). The investor must then deduct the $75 premium paid for the option and would walk away with a net profit of $1925.

Of course, the investor would also need to consider the commission they paid for the initial order and any charges incurred when they sell their shares. For the cost of the premium, the investor has protected some of the profit from the trade until the option’s expiry while still being able to participate in further price increases.

Protective Put

The protective put, or put hedge, is a hedging strategy where the holder of a security buys a put to guard against a drop in the stock price of that security.

Protective Put Construction
Long 100 Shares
Buy 1 ATM Put

A protective put strategy is usually employed when the options trader is still bullish on a stock he already owns but wary of uncertainties in the near term. It is used as a means to protect unrealized gains on shares from a previous purchase.

Unlimited Profit Potential

There is no limit to the maximum profit attainable using this strategy. The protective put is also known as a synthetic long call as its risk/reward profile is the same that of a long call’s.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Purchase Price of Underlying + Premium Paid
  • Profit = Price of Underlying – Purchase Price of Underlying – Premium Paid

Limited Risk

Maximum loss for this strategy is limited and is equal to the premium paid for buying the put option.

The formula for calculating maximum loss is given below:

  • Max Loss = Premium Paid + Purchase Price of Underlying – Put Strike + Commissions Paid
  • Max Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the protective put position can be calculated using the following formula.

  • Breakeven Point = Purchase Price of Underlying + Premium Paid

Example

An options trader owns 100 shares of XYZ stock trading at $50 in June. He implements a protective put strategy by purchasing a SEP 50 put option priced at $200 to insure his long stock position against a possible crash.

Max Loss Capped at $200

Maximum loss occurs when the stock price is $50 or lower at expiration. Even if the stock price nosedived to $30 on expiration, his max loss is capped at $200. Let’s see how this works out.

At $30, his long stock position will suffer a loss of $2000. However, his SEP 50 put will have an intrinsic value of $2000 and can be sold for that amount. Including the initial $200 paid to buy the put option, his net loss will be $2000 – $2000 + $200 = $200.

Unlimited Profit Potential

There is no limit to the profits attainable should the stock price goes up. Suppose the stock price rallies to $70, his long stock position will gain $2000. Excluding the $200 paid for the protective put, his net profit is $1800.

Note: While we have covered the use of this strategy with reference to stock options, the protective put is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the protective put in that they are also bullish strategies that have unlimited profit potential and limited risk.

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