The protective put is a hedging strategy that consists of buying puts to guard or hedge against a drop in the stock price of that particular security. You need to already own the underlying stock, before you buy the puts.
Here’s how it’s constructed:
Long 100 Shares – Buy 1 ATM Put
The protective put strategy should be deployed when you’re still bullish on the underlying stock but wary of uncertainties in the short term. It’s used as a means to protect unrealized gains on shares from a previous purchase.
Maximum Profit Potential
The protective put is sometimes known as a synthetic long call since its risk/reward profile is the same as that of a long call. There’s no upper limit to the maximum profit attainable using this strategy.
You can calculate the maximum possible profit using the formula below:
- Profit = Price of Underlying – Purchase Price of Underlying – Premium Paid
Maximum Potential Loss
The maximum potential loss for this strategy is limited to the premium paid for buying the put option.
You can calculate the maximum possible loss using the formula below:
- Max Loss = Premium Paid + Purchase Price of Underlying – Put Strike + Commissions Paid
- Max Loss Occurs When Price of Underlying = Strike Price of Long Put
The price at which breakeven occurs can be calculated using the following formula.
- Breakeven Point = Purchase Price of Underlying + Premium Paid
Protective Put Example
Let’s say you own 100 shares of IBM stock which is trading at $50 in April. So you decide to hedge this position by buying a JUL 50 put option priced at $200 to insure against a possible crash.
The maximum potential loss when using a protective put is limited to the $200 it cost you to buy the put option. Even if the stock price nosedives to $30 upon expiration, the absolute maximum you can lose is $200.
To prove the point, at $30 your long stock position will suffer a loss of $2000. However, your JUL 50 put will have an intrinsic value of $2000. Including the initial $200 it cost you to buy the put option, your net loss will be $2000 – $2000 + $200 = $200.
One of the biggest advantages of using a protective put is that there’s no limit to the amount of profits you can make should the stock price shoot up. Let’s say the stock price of IBM rallies to $70, your long position will gain $2000. Excluding the $200 paid for the protective put, your net profit is $1800.
To make the above example easier to understand we’ve left broker commissions out of the equation. If you were to make this trade for real you’d have to account for broker commissions on both the original stock purchase and the put option. The amount you have to pay will vary from broker to broker but you’ll typically pay around $10 to $20 if you use a retail broker like optionsXpress.
As you gain experience you’ll want to start stringing together more complex options strategies that require three or more individual contracts. When this happens you might want to consider using a broker that specializes in frequent trading, as three or more contracts at $20 per contract soon adds up.
OptionsHouse is an excellent broker for frequent traders since they offer excellent customer service and one of the best trading platforms around, on top of that their commissions start at only $0.15 per contract (+$8.95 per trade) for frequent traders.
The protective put is more of a hedging strategy than a straight out options strategy, since it requires you to already own the underlying stock which you’re hedging against. Because of that this isn’t a strategy you can practice, but it’s important you understand the theory behind if you’re going to trade it.
Since it has a limited downside and unlimited upside this strategy is ideal for beginners and intermediate investors who either manage their own IRA account or want to try out hedging their long term open positions.