This article discusses protective puts, how they work, and whether they’re a good idea for investors.
Definition and Examples of a Protective Put
A protective put is a type of a put option strategy that helps investors limit their maximum losses from owning a stock. This strategy is often employed by investors who are bullish on a long-term price rise for a stock but bearish over the short term.
Alternate name: Married Put
When you own a stock, you can earn a profit if that stock gains value. You can lose money if the stock’s price falls. Your maximum loss is equal to the value of a share, multiplied by the number of shares you own. For example, if you own 100 shares of XYZ, each worth $25, you have $2,500 invested. If XYZ becomes worthless, you could lose $2,500. Continuing the above example, you’ll be employing a protective put if you buy a put option on XYZ with a strike price of $20 in addition to the shares you own. With this put option, you can sell your shares to the option seller for $20 each, no matter what their market value is. You do have to pay a premium when you buy an option, so that also factors in your profit or loss calculations. This premium is typically higher the closer the strike price is to the stock’s current market value and the more time there is between the current date and when the option expires. They’ll also tend to be higher for more volatile securities.
How Does a Protective Put Work?
You can think of protective puts as being like insurance. You pay a premium to buy a put with a strike price below the current value of a stock you own. In exchange, you limit your maximum loss on the stock to the difference between the stock’s current value and the strike price listed in the put. Let’s illustrate that by continuing with the example of XYZ. You have 100 shares of XYZ that you bought at $25 per share. You also have a put on XYZ with the strike price of $20 for which suppose you paid $2 as the option premium. So your break-even point is $20 - $2 = $18 Now, if the price of XYZ shares begins falling, you can limit your loss by exercising your put option and selling shares of XYZ at $20 a share. Suppose the price of XYZ falls to $10 per share. Your loss per share on the XYZ shares you bought would be $10 - $25 = -$15. Your gain by exercising your put and selling XYZ shares at $20 would be $20 - $10 = $10. Your total net per share is: Loss on stock price + Gain on put exercise - options premium = -$15+ $10 -$2 = -$7 Using the numbers above, your maximum loss would equal ($7) * 100 = $700, which is a much smaller loss than the $1,500 (-$15 * 100) maximum loss without the put. At the same time, you are under no obligation to exercise the put, meaning you can choose to let it expire, losing only the premium you paid. This means that if the price of the stock you’re holding rises, you won’t limit your potential profit.
Pros and Cons of a Protective Put
Pros Explained
Limit your potential losses: With protective puts, there is a minimum price you can sell your shares at, limiting how much you can lose from owning a stock.No effect on potential gains: Because you’re not obligated to exercise a put, it won’t impact your potential gains if the price of the stock rises significantly.
Cons Explained
You have to pay a premium for the option: Each time you buy a put, you pay a premium, which means you have to pay for the protection.Regularly buying protective puts can create drag on your returns: If you buy protective puts on a regular basis, you could wind up spending significant amounts on premiums. Over the long term, this could reduce your overall returns, especially if you pay high premiums.
What It Means for Individual Investors
Protective puts are an option for investors who want to own a stock, but who are worried about a significant downturn in its price. You can use them if you want to invest in a security but can’t afford to experience a catastrophic loss. Alternatively, you can rebalance your portfolio to reduce investment risk, such as by increasing your bond holding compared to stock holdings. For long-term buy-and-hold investors, protective puts won’t be particularly useful as they’re more effective for limiting losses in the short term. If you’re investing for something like retirement, protective puts probably won’t be a useful strategy for you.
