The protective put is an option strategy where an investor buys a put option for an underlying stock that he owns in order to hedge against a drop in that stock’s price.
This is a useful strategy to protect against the fall in a stock’s price. By reading this article, investors will gain a basic understanding of the protective put and feel better prepared to put this strategy to use.
The protective put strategy is also known as the married put strategy.
This strategy is used when an investor is bullish on a stock that he already owns but uncertain about the stock’s price in the near-future.
The protective put has unlimited potential profit. When using this strategy, profit is equal to the price of the stock minus the purchase price of the stock minus the premium paid when buying the put option. Since the price of the stock can theoretically rise to an infinite amount, the potential profit from this strategy is uncapped.
The potential maximum loss from this strategy is equal to the premium paid when purchasing the put option. An investor takes on the risk of losing the premium amount in order to protect his stock from downside risk. The protective put is more of a capital preserving strategy, rather than a profit-making strategy.
Let’s look at an example of a protective put.
Assume an investor owns 100 shares of stock ABC, which is trading at $80. The investor establishes a protective put by purchasing a put option with a strike price of $80 that expires in a month. He purchases the put option for a premium of $2 per share.
The buyer’s maximum loss will occur if the stock falls below $80 at expiration. Assume ABC falls to $75. With the put option in place, the buyer can sell the shares of stock at $80 instead of the market price of $75. Therefore, he does not lose any profit from the stock’s drop in price. His only loss comes from the premium he paid for the put option, which was $2 per share.
The investor’s maximum profit is uncapped. Suppose ABC went up to $90 at expiration. The buyer will profit $10 per share because of the stock’s move from $80 to $90. After accounting for the cost of the put option, which was $2 per share, the buyer’s total profit becomes $8 per share.
If the stock’s price rose to be higher than $90 at expiration, then the buyer’s profit would increase even more. The higher the increase in stock’s price, then the higher the increase in profit for the investor.
After looking at this example, investors should have a better understanding of how the protective put works. If an investor owns a stock and wants to hedge against a potential fall in that stock’s price, then the protective put is the perfect strategy to use.