Before being used for speculative reasons, options were originally designed to hedge your trading risk. Understanding the protective put strategy is essential if you wish to reduce your loss risk while maintaining a potential gain. This strategy, involving buying shares and a put option, is basically an insurance policy for your investment. Check out what a protective put is, see a protective put graph, and look at our protective put example.
Key takeaways
- Protective puts are a way to safeguard against losses while still allowing for potential upside.
- In simple terms, you will buy 100 shares and a put option to cover your losses if things go bad. This approach involves paying a premium, similar to buying insurance for your investment.
- The best thing about this strategy is that it limits your losses at a lower level compared to simply buying stocks while still giving you an uncapped profit potential.
What Is the Protective Put Strategy?
First of all, let us define the protective put strategy. The protective put strategy involves buying a put option to safeguard against potential losses in an owned stock. As we said in the introduction, this is basically a micro-insurance policy for your trade.
By purchasing a put, you secure the right to sell your stock at a specific price, known as the strike price, if the market takes a downturn. This predetermined price ensures that you won’t lose more than you’re willing to risk, no matter how far the stock might fall.
P&L Analysis – The Typical Protective Put Graph
Here’s the profit & loss (P&L) profile of your protective put strategy:
In short, the protective put graph above tells you that this is how the strategy works:
- Purchase a Put Option: Buy a put option for each 100 shares of the stock you own. This option gives you the right, but not the obligation, to sell those shares at the strike price before the option expires.
- Set a Strike Price: Take your time to choose the right strike price for your strategy. If the stock price drops below this level, you can still sell at the strike price, reducing your potential losses. From the chart above, you can see that your losses are capped on the left-hand side of the P&L, while your profit is only reduced by the put premium (see next point) and remains potentially unlimited.
- Pay a Premium: Like the insurance, you pay a premium for this protection (the only difference is that you pay the full premium upfront rather than in installments).
A protective put strategy is particularly useful when the market is unstable or when you want to protect unrealized gains. It allows you to stay invested in a stock while minimizing the risk of significant losses.
Married Put vs Protective Put – Is There a Difference?
What is a protective put? And what is a married put? In practice, “married put” and “protective put” are often used interchangeably. Both terms describe a strategy where a long stock position is combined with a put option for downside protection. The distinction is subtle: a married put specifically refers to when the put covers the entire long position of the asset.
Specifically, the protective put example you will find in the section below will actually be a married put (meaning that we’ll assume we own 100 shares and buy one put on the same company).
Despite this, it’s fair to view the married put vs protective put strategy as synonyms since the core principle remains the same.
A Real-Life Protective Put Example
An example will do more than any theoretical explanation by showing how the protective put strategy works in a real-world scenario. Imagine you’ve decided to invest in 100 shares of Bank of America (BAC), a stock you believe has solid potential given the current high-interest rates in the U.S.
You buy these shares at $40.75 each, totaling an investment of $4,075. Now, while you’re optimistic about BAC’s growth, you’d like to shield yourself from potential downside risks. This is where the protective put comes into play.
You purchase a $40 put option, expiring in a month, as found on our options screener with the following protective put graph:
As you see from the chart above, this put option acts like a safety net. Should BAC’s stock price plunge below $40 by the expiration date, your maximum loss would be capped at $156. This cap means you would lose $156 if BAC trades at $39.99, $20, or even $1, safeguarding your investment from drastic losses.
Here’s a quick breakdown:
- Initial Share Price: $40.75
- Put Option Strike Price: $40
- Option Premium: $0.81
- Breakeven Price: $41.56 ($40.75 + $0.81)
The breakeven price of $41.56 is the point where the gains from a rising BAC stock offset the cost of the put option.
One of the significant advantages of employing the protective put strategy is that it doesn’t cap your potential profits (as you see in the protective put graph above), unlike strategies such as credit or debit spreads. If BAC rises as expected, your earnings will be slightly less due to the cost of the put, but this trade-off is minimal compared to the peace of mind it provides.
Consider BAC’s historical performance:
The stock has been on an upward trend, recently reaching a peak well above your breakeven price. This could signal another potential rally, making it an enticing opportunity. However, it’s crucial to evaluate BAC’s financials, dividend performance, and overall market conditions before fully committing.
Protective Put Pros and Cons
It is fairly easy to understand the pros and cons of the protective put strategy. Here is a table with the advantages and disadvantages of the protective put strategy:
Pros of Protective Put Strategy
- Protection from Declines: A protective put acts as a safety net, shielding your investment from significant stock price declines. This peace of mind can be invaluable, especially in volatile markets.
- Potential for Gains: Unlike some strategies that cap potential profits, a protective put allows investors to keep their stock positions open and benefit from any price increases. This means you can ride the wave of a bull market while being prepared for downturns.
Cons of Protective Put Strategy
- Option Premium: Purchasing a protective put requires paying a premium. If the put is not exercised, this cost will reduce your overall returns. It’s similar to paying for insurance you might not use.
- Time Decay: As time passes, the option’s value decreases—a phenomenon known as time decay. This can erode the benefit of the protective put, especially if the market remains stable or trends upward.
Additional Factors to Consider Before Opting for a Protective Put
The protective put strategy is a fairly simple trade setup to understand, but there are a few crucial factors to consider before diving in. While the protective strategy is designed to protect your investment, elements like time decay and market volatility can impact its overall effectiveness and cost.
In fact, here is a table that summarizes the concepts of time decay and implied volatility (with their effect on options):
Time Decay
Time decay, or theta, is a critical aspect to consider when purchasing put options. Over time, options tend to lose value if all other factors remain constant. This loss in value might not be obvious if the underlying stock price makes significant moves. However, if the stock price remains relatively stable, options you hold might decrease in value due to time decay. This aspect of the protective put can lead to notable costs if the expected decline in stock price does not occur.
Therefore, here is what you should consider when it comes to time decay:
- Strike Price Choice: The strike price selected impacts both the cost of time decay and the level of protection. Lower strike prices are cheaper but offer less protection for minor stock price changes.
- Impact on Value: Put options with strike prices significantly lower than the stock price experience less time decay. Conversely, options closer to the current stock price may be pricier and more susceptible to time decay.
- Strategic Timing: Investors aiming for maximum protection might choose a put with a strike price near the stock’s current value, accepting higher costs and potential time decay.
Volatility
Volatility is another essential factor when considering a protective put. Implied volatility (IV) in options contracts can either benefit or hinder the buyer. A decrease in volatility can make it harder to profit from a protective put, while increased volatility might boost potential profitability, albeit with higher option prices.
Here are the key points to consider on volatility:
- Market Timing: Purchasing put options before anticipated high volatility events, such as earnings reports, may be strategic. However, these options will generally be more expensive. It is also likely that the IV will collapse after the event is over or the news is out (a phenomenon known as “IV Crush”), a factor that can reduce the value of your option.
- Volatility Impact: As implied volatility rises, option prices typically increase, potentially enhancing profitability. Conversely, when market uncertainties decrease, options prices may fall due to reduced volatility.
- Cost-Benefit Analysis: Consider the increased price of options during periods of high volatility against the potential for greater returns.
Therefore, even when considering a simple protective put strategy, it’s important to account for time decay and volatility. While understanding how the value of your stocks will change can be straightforward, option contracts (and, in general, the derivative market) are more complicated. A change in the underlying price is not the only factor that could impact the profits and losses of your portfolio, which is why we stressed the concepts of time decay and implied volatility above.
When Would Opening a Protective Put Be a Good Idea?
At this point, you surely get what a protective put is: you buy 100 shares and protect your position with a put contract. That’s fine, but is there something more to consider when deciding if the protective put strategy is right for you? Absolutely. Let’s look at some scenarios where a protective put might be advantageous.
Early Selling Concerns
Imagine you’re worried about selling your stock too early and then needing to buy it back at a higher price.
Let’s look at a quick protective put example. For instance, take AAPL (currently trading at $229): you own 100 shares, and you’re not sure if the stock will continue to rise. At the same time, you don’t want to be out of the game in case it does. You could buy a protective put at some point below $229, let’s say at $210: for every share owned, one contract would cost you around $19.
Let’s follow our protective put example: if AAPL falls back below $210 before options expire (the third Friday of the month), you’ll be able to sell it for that price by exercising your put option; this means that your loss will be limited at about 9%, as compared to a potential decline of over 20% without a protective put.
The best thing here is that, once your put option expires, you can keep your shares and repeat this same strategy in the future and go back to profiting from a stock price increase (or, if the bear market is not over yet, you can just continue to buy put options).
This concern can be a real headache, especially in volatile markets. A protective put can offer peace of mind by allowing you to hold your stock longer without the fear of significant losses. So, you don’t have to fret about timing the market perfectly.
Employment Restrictions
If the stock in question belongs to the company you work for, you might face restrictions that prevent you from selling it. Even if you’re not restricted, there could be personal reasons for wanting to hold onto your shares. In these cases, a protective put can be a smart way to secure your investment while respecting your employment requirements.
We know that this is certainly not a frequent case and does not constitute your typical protective put example, as it applies to a limited number of investors. Still, having one more tool at your disposal is never a bad thing.
The bottom line here is that the protective put strategy allows you to maintain your position without having to sell your shares outright.
Tax Implications
Tax considerations can also play a significant role in choosing a protective put strategy. Buying a protective put can lead to a scenario where your stock is considered constructively sold, especially if the put is either at-the-money or in-the-money. This could have tax consequences that might not be in your favor. It’s crucial to consult a tax advisor to understand the full implications of a protective put strategy and ensure that you’re not facing unexpected tax liabilities.
