What is a Protective Put?
A protective put is a risk-management strategy using options contracts that investors employ to guard against the loss of owning a stock or asset. The hedging strategy involves an investor buying a put option for a fee, called a premium.
Puts by themselves are a bearish strategy where the trader believes the price of the asset will decline in the future. However, a protective put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty.
Protective puts may be placed on stocks, currencies, commodities, and indexes and give some protection to the downside. A protective put acts as an insurance policy by providing downside protection in the event the price of the asset declines.
How a Protective Put Works
Protective puts are commonly utilized when an investor is long or purchases shares of stock or other assets that they intend to hold in their portfolio. Typically, an investor who owns stock has the risk of taking a loss on the investment if the stock price declines below the purchase price. By purchasing a put option, any losses on the stock are limited or capped.
The protective put sets a known floor price below which the investor will not continue to lose any added money even as the underlying asset’s price continues to fall.
A put option is a contract that gives the owner the ability to sell a specific amount of the underlying security at a set price before or by a specified date. Unlike futures contracts, the options contract does not obligate the holder to sell the asset and only allows them to sell if they should choose to do so. The set price of the contract is known as the strike price, and the specified date is the expiration date or expiry. One option contract equates to 100 shares of the underlying asset.
Also, just like all things in life, put options are not free. The fee on an option contract is known as the premium. This price has a basis on several factors including the current price of the underlying asset, the time until expiration, and the implied volatility (IV)—how likely the price is going to change—of the asset.
Breaking Down a Protective Put
A protective put strategy is analogous to the nature of insurance. The main goal of a protective put is to limit potential losses that may result from an unexpected price drop of the underlying asset.
Adopting such a strategy does not put an absolute limit on potential profits of the investor. Profits from the strategy are determined by the growth potential of the underlying asset. However, a portion of the profits is reduced by the premium paid for the put.
On the other hand, the protective put strategy does create a limit for potential maximum loss, as any losses in the long stock position below the strike price of the put option will be compensated by profits in the option. A protective put strategy is typically employed by bullish investors who want to hedge their long positions in the asset.
Protective Puts Example
Going back to the well on Apple, let’s say you have a million-dollar position in AAPL stock. For a round number, let’s say you have 7,500 shares that you bought back when the iPod came out.
You could go out in the options market and buy 75 contracts of the January ’23 130 puts, which would cost $12.70 per share or $95,250. Then, you would have protection against AAPL falling for the next ~7 months.
Now, sharp-eyed readers may notice that something is wrong with this trade.
First, the options cost 95,000 bucks, and where would we get the money to buy them without selling for tax purposes? I suppose we could borrow it, but that comes at a cost.
The second problem is that these options are really expensive. This is because as of June 14, 2022, the S&P 500 is down about 10% from last week’s high, and the market is in utter chaos. Everybody wants these puts, but the time to buy them was months ago when they traded for a fraction of the cost.
In this case, it may be best to sell the shares and pay taxes, but if the stock were back at its all-time high of roughly $175 and the options were cheap because volatility was low, that would be a nice trade.