October 31, 2017

Understanding the Protective Put

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If you could have protection while investing in stocks, wouldn't you jump at the chance? That's what a protective put offers. It's not a guarantee - there can still be losses. But, with the right strategy, it can help you make the most of your investment.

What Is a Protective Put?

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You can think of a protective put as an insurance policy. You buy this option when you own at least 100 shares of a stock. If you buy the option at the same time you buy the stock, it's called a married put. Married or not, the put works the same.

The protective put gives you the right to sell your shares at the designated strike price. You buy the option at the strike price you think is best. Generally, investors who buy these options do so when they feel bullish, yet slightly worried about the stock. It's a way to protect the investor on the back end should the stock not perform like they thought.

A protective put is an alternative to the stop order. When you own a stock, you can ask your broker to create a stop order. It doesn't cost you anything (unlike the protective put, which costs a premium). The stop order, however, doesn't leave you in control. The only thing you choose is the "stop price." This is the price you instruct the broker to sell your stock. It's an automatic process. It doesn't give you time to think about your decision. With a stop order, if the market price hits your stop price, the stock trades.

A protective put, on the other hand, gives you choices. You don't have to sell your stock if it hits below the strike price. You do have the right to sell it at that price if you want, however.

Maybe you think the dip in stock price is just temporary, though. You can wait it out with a put. With a stop order, you can't wait it out.

What Happens When a Stock Falls Below the Strike Price?

You set the strike price and buy the protective put. What do you do if the stock actually dips below the strike price? You have a few choices:

  • You can exercise the put and sell the stock at the strike price. You walk away with the gains from selling minus the option's premium.
  • You can wait it out. You don't have to sell the stock just because the stock price dipped low enough.
  • If you wait it out, you can even sell the put back to the market to close your position. The idea is to recoup some of your premium.
  • If you wait it out, you can just wait and see what happens. If the stock price doesn't increase, you may exercise your right just before expiration. If the stock price does increase, you can let the option expire worthless. You lose your premium in this case, though.

The Benefit of the Protective Put

Your protective put is similar to the insurance you have on your car. You carry the insurance "in case" something happens. You don't want something bad to happen. But you also want to be prepared in the event that something does happen. The insurance will protect you from financial destruction.

The same is true for the protective put. You buy an insurance policy on your underlying asset. In a perfect world, you'd like the asset to stay in good condition, just like your car. But you know the world isn't perfect and things can happen. If they do, you have the insurance policy to protect you.

Think of the protective put as a "floor." It's the lowest price you're willing to accept for your stock. Of course, you'd much rather see the stock's price skyrocket and you make money. But, if it doesn't, you at least have a minimum amount you'll receive for the stock.

Some might say that the protective put limits your profit, and it does. But it also protects your losses. Your profits are only limited by the premium you pay. But the downside is set by the strike price or the floor.

Here's an example:

John bought ABC stock for $30/share. A few weeks later, the market forecast made John nervous. He wasn't sure what ABC stock was going to do. He knew he didn't want to lose money on the deal, so he bought a protective put with a strike price of $30. The option has an expiration of 3 months and a $3 premium.

In 2 months, the stock price dropped to $25. If John were to sell his stock on the open market, he would lose $500:

$3,000 ($30 x 100 shares for the purchase) - $2,500 ($25 x 100 shares current price) = $500

But, because John has a protective put, he can sell his stock for $30. John limits his losses with this option.

$3,000 ($30 x 100 shares for the purchase) - $3,000 ($30 x 100 shares current price) - $300 ($3 premium x 100 shares) = $300 loss

Let's say John decided to ride it out. He didn't exercise his option when the price fell to $25 because he felt bullish. At the end of the 3 months, the stock price reached $35. John's predictions were right. Here's how he ended up.

$3,500 ($35 current market price x 100 shares) - $3,000 (original cost of shares) - $300 (option premium) = $200 profit

In reality, once the stock hit $33/share, John is at his break-even point.

Breaking Even on a Protective Put

If you are able to break even on an option contract, it's considered a good trade. You didn't gain, but you didn't lose. In this case, your break-even point is as follows:

Market price = Original share price + premium per share

In the above example, John paid $30 for each share plus $3 premium for the option contract. Once the stock hit $33, John hit his break-even point. Anything above $33 and he would see a profit.

Times to Use a Protective Put

Aside from feeling bullish, there are times when a protective put can be put to best use. Again, because it's a layer of protection, it can help you stay in control.

For example, if there is talk of a big news announcement about the market, you might want a protective put. If you are unsure about how the announcement will affect your stock, it makes sense to protect your investment. If the announcement is good and your stock increases, you let your "insurance" expire unused. But, if the price drops dramatically, you have protection.

Perhaps you already realized some financial gain from the stock, but want to see if you can squeeze out a little more. You can set the protective put at the strike price you are happy with and then ride it out. If the stock plummets, you can still sell at your designated price and realize your gains.

Of course, both situations require a premium payment. You'll have to take that into account when determining your profit.

Bottom Line

The protective put gives you control. It lets you protect your downside. It can help you limit your losses. It's not a guarantee of profit, though. Investing in stocks is still a gamble. You still stand to lose your investment. With the put, however, you can obtain a temporary insurance policy to help you keep your losses to a minimum.

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