Protective Put

Publication Date :

27 Jun, 2022

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Table Of Contents

Protective Put Definition

A protective put refers to an options strategy investors use to protect a long stock position. The investor owning the shares of a stock can buy a put option to cover those shares. The put option strategy can protect extraordinary gains and limit the possible losses.

The strategy helps to minimize the risk of owning a stock. It's like insurance against a drop in stock prices. It gives coverage despite the depth of the drop, at the same time allowing profits to accrue as long as the market keeps going up. The other names used to mention it are married put and synthetic call.

A protective put refers to a risk management strategy of buying put options against the shares owned or purchased. It is also called a synthetic call or married put.
The primary intent of buying put options with a strike price equal to or close to the stock price is to protect long stock positions.
It functions like insurance, where the investor pays the premium price to reduce the impact of an unexpected downtrend.
It can restrict the losses and, at the same time, does not put a limit on the potential profit.

Protective Put Strategy Explained

A protective put option is a portfolio protection strategy. It protects against individual stock-level loss and functions as investment insurance. The investor buys the put option by paying a premium to the put writer, who is portrayed as an insurance seller. Also, the put option comes with an expiration date, providing coverage for a specific duration. A higher strike price indicates less risk is associated with the investor and more risk is associated with the put writer.

Its prime objective is to limit potential losses, and this safeguarding property increases the demand for protective put options in the market. The strike price feature sets a minimum price at which an investor can sell the shares, even if the price falls to unexpected levels during the put option duration; in this way, bullish investors hedge their long positions. At the same time, the strategy does not hold an absolute limit on the investor's potential profits. The growth potential of the asset determines profits. However, the premium paid for the put reduces a certain profit portion.

Example

Mr. A buys 100 shares of company A stocks at $100 per share. Since the company showcases growth potential to outperform the overall market in the future, Mr. A does not want to sell the stocks to make a short-term profit but to hold it for a long period; hence one put is purchased against the shares to get protected from the unexpected downtrend. The put option strike price is $93, and the premium paid is $3. If the price falls below the purchase price and the put option is exercised, the investor can restrict the loss.

Break-Even = Purchase price + Premium paid

= $100 + $3

=$103

Profit or Loss = (Strike price - purchase price - premium paid) * Number of shares

= ($93 - $100 -$3) * 100

= -$1000

If the stock price increases to $110 and Mr. A decides to sell the shares, the profit will be:

Profit = (Selling price – purchase price – premium paid) * Number of shares

= ($110 - $100 - $3) * 100

= $700

In the absence of a protective put, if the stock price falls below the purchase price, the investor will incur a loss, and if the price remains the same as the purchase price, there will be no profit or loss.

Pros & Cons

Pros

Limit risk: Help reduce potential loss by setting a floor price for an investor to sell the shares, limiting how much loss owning could've brought. Maximum loss is limited and equated to the premium paid for obtaining the put option.
Less complex: It is a common strategy and does not require special expertise and time.
No restriction on gains: If the market gets bullish, it won't impact the potential profits.

Cons

Payment of premium: Buying a put option involves paying a premium.
Short lifespan: The put option duration is short, and investors have to buy put options may be in a regular manner. Subsequently, the cost of put options affects the profit.

Protective Put vs. Covered Call

Protective put and covered call have been very popular among various option-based strategies in exhibiting hedging performance. Let's look into the difference between them:

Protective Put	Covered Call
Buy put options against the stock	Sell call option against the stock
Incur cost of the premium	Income in the form of premium
Protect during downtrend	Apt during neutral to bullish market scenario
It is less complex	Perceived as a complex strategy
It is also referred to as married put or synthetic call	It is also called "buy-write"
The primary aim is to minimize the possible loss associated with the stocks owned	Generate additional income from the stocks owned
It does not limit the potential profit if the stock price rises	Limit the profit potential

Frequently Asked Questions (FAQs)

What is a protective put example?

An investor buys 100 shares of a fundamentally strong company's stock for $100 per share. The price movement of the stock is showing an overall uptrend. However, to protect the investment from a sudden unexpected fall in price, the investor purchased a put option corresponding to the shares purchased. The put option strike price is $105, and the investor paid $3 as a premium. If the price falls below the purchase price and the put option is exercised, the investor will get a minimum profit without obtaining a loss.

What is covered call and protective put?

A covered call strategy involves selling a call option against the shares purchased or owned. "Buy write" is the strategy of buying stock and selling calls simultaneously. "Overwrite" is the selling of calls against stock already purchased. In contrast, the protective put involves buying a put option to protect the investment or position.

Are protective puts worth it?

Put option comes with an expiry date. Therefore, if the stock price does not fall below the strike price during the put option duration, the premium paid will turn into a cost without benefit.