October 31, 2017

Understanding the Protective Put

Read more about Options Trading

A protective put offers protection when investing in stocks. It's not a guarantee against losses. But coupled with the right strategy, a put can help make the most of your investment.

What Is a Protective Put?

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Think of a protective put as an insurance policy. You can 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.

It 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.

You Should Know: Investors usually buy puts when they feel bullish, but slightly worried about the stock. It's a way to protect the investor on the back end should the stock not perform as they hoped.

Protective Put vs. Stop Order

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 that 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 a current dip in stock price is just temporary. You can wait it out with a put, NOT a stop order.

What Happens When a Stock Falls Below the Strike Price?

So you set the strike price and buy the protective put. What do you do if the stock 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 car insurance, which you buy "in case" something happens. You don't want something bad to happen. But you also want to be prepared if it does.

With 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.

You Should Know: You can also 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, which 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.

Consider this example:

John bought ABC stock for $30/share. A few weeks later, the market forecast made John nervous. 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 since 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

Now let's say John 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

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 moments you feel bullish, there are good uses for a protective put. Remember, as an added layer of protection, it can help you stay in control.

Consider these examples.

1. A big market-related announcement is coming. If that announcement might affect your stock, you may want a protective put. It makes sense to protect your investment.

Say the annoucement is negative and your stock price drops dramatically. Now you have some protection. And if the announcement is positive and your stock increases, you let your "insurance" expire unused.

2. You've already realized some financial gain from the stock, but want to see if you can squeeze out some more.

You can then set the protective put at the strike price you are happy with and ride it out. If the stock plummets, you can still sell at your designated price and realize your gains.

NOTE: Both these 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 by protecting your downside. It can help you limit your losses.

But it isn't a guarantee of profit. Investing in stocks is still a gamble. You can always lose your investment.

With the put, however, you do obtain a temporary insurance policy to help you keep your losses to a minimum.

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