Buying a Protective Put

Module 3: Basic Strategies
Lesson 3: A Protective Put

The Protective Put and the Married Put are essentially the same in that they protect you from the risk of loss. What differentiates the two is that a Protective Put is when an investor buys a Put option for shares of stock he/she already owns.

It's considered protective because investors use this strategy to protect profits they have accumulated in a trade. And like the Married Put it's also used to insure (hedge) the investor against a loss in trading capital (money).

Protective Put Example

Suppose you had initially purchased 100 shares of stock XYZ @ $50 per share. Excluding commissions it would have cost you $5,000 ($50 *100). Four months later the stock is now trading at $80. You have an unrealized profit of $3000.

Usually you would have to sell shares of the stock to lock in your profits. This however prevents you from fully participating in a future rise of the stock price for all 100 shares.

Buying a Protective Put solves this dilemma. It protects your unrealized profits so that you don't have to sell any shares of the stock.

Remember that a Put option gives its owner the right, but not the obligation, to sell a certain stock at a specified price on or before a specified date.

Instead of selling shares you would buy a Put option (Protective Put) with a strike price of $80. You've now locked in your gains and have the right to sell your stock for $80. And like any type of insurance, you have to pay a premium (the cost of the option). The Put option cost you $400 ($4 *100).

You've essentially insured yourself against a loss. Even if the stock price fell all the way to $30, you'd still have the right to sell the stock at $80 up until the day the Put option expires.

Profit Calculations:
You paid a total of $5400 ($5000 for the stock and $400 for the Put option).

You sold 100 shares at $80 and received $8000 in your account.

$8000-$5400 = $2600 gain.

So if you are following the example, you can see that a Protective Put limits the amount of money you can lose on a stock investment, but still allows you to participate in the unlimited upside potential.

Rolling Up Your Options

If the price of the stock continues to rise past $80 you might want to sell the option you bought and then buy another one at a higher strike price.

This way you can lock in the profits from the move higher. This is considered rolling up your options.

So if the stock jumps from $80 to $110, the $80 Put option you bought wouldn't be as useful to you anymore because it doesn't provide adequate coverage against a lost in value. It's like being underinsured. So it would be wise to roll up your $80 Put and buy a $110 Put.

Of course the cost of the Put eats into some of your gains, but the stock is now trading for $110. You initially paid $50 for the stock. You're attempting to lock in your unrealized gain of $6,000. So even if the total cost of both puts was $800, it was worth the cost.

Worse case scenario you end up with a profit of $5,200 ($6000-$800).

Without the protection (Put) you would be at risk of losing not only your unrealized gain of $6000, but also your initial $5000 investment.

If you're like me and have had a stock go to $0 on you, then you will also appreciate the benefit that a Protective Put offers. In this case the cost of the Put would be negligible.

To adequately protect your profits you need to purchase a number of Put contracts equivalent to the number of shares held. Please see the Married Put example for a full explanation of how many contracts to buy.

Advantages of Protective Puts

• Allows you to hold on to your stocks and participate in the upside potential while at the same time insuring against any losses
• The cost to buy the insurance is relatively cheap considering how much money you are protecting

Disadvantages of Protective Puts

• Cost of the Put option eats into your profit
• The option has a limited lifespan (it expires) and has to keep being renewed (buying another option)

Lesson Review

A Protective Put is when an investor purchases a Put option for shares of stock he/she already owns. It is used to protect profits that have accumulated in a trade.

• Establishing this protective position is what the investment community would consider as hedging your investment
• The Put option is used lock in your stock gains while providing you with insurance against a stock market loss
• Purchase a number of Put contracts equivalent to the number of shares held

If you're ready proceed to Lesson 4: "Buying Puts".

You can proceed to Module 4: Stock Charts whenever you feel you are ready.

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