Protective Put — What is a Protective Put?
A protective put sounds like a guard dog overseeing a herd of sheep. It isn’t. It is an option strategy to protect your profits, or even increase your profits, against a stock you own.
If you are an investor you already know there are various methods you can employ to protect your profits and hedge your risks. Otherwise you wouldn’t be in the market, right?
Protecting your investment’s first line of defense is usually the stop loss order. If you don’t know what a stop loss order is, please do an online search. Your online brokerage house undoubtedly has tutorials you can read or watch as well.
Some people write call options and that is a great strategy but not the subject of this article. This article is about a strategy called a protective put.
A protective put is nothing more than a put bought against a stock you already own. It is a second cousin to the guy called stop loss. It has both benefits and drawbacks.
In case you don’t know, when you buy a put option, you stand to profit as the market goes down. When you buy a protective put, you stand to profit as the market goes down. Do you see the benefit?
You have a profitable position and you want to keep it. The protective put is your champion in this case.
For whatever reason, you’ve turned bearish on your holding. That happens all the time. But what doesn’t happen all the time is the investor protecting his position when the stock starts a downward slide.
If you were to use only a stop loss order, you would exit your position when the stock slid to that price. You have essentially locked in a profit but not as big a profit as possible.
By the way, when you make money, your investment strategy is brilliant. However when you really capitalize and make a huge profit, your investment strategy is pure genius.
The usual example of this process involves 100 shares of a $100 stock. Your total capital outlay would be $10,000 not counting commissions and fees.
The stock rises in price by $20 so it is now trading at $120 per share. If you do the math, you will compute you have a 20% gain.
Like I said above you become not sure if this issue can maintain the $120 price so you decide to place a stop loss at $110. Hang on we will get to the protective put.
You like this issue but you don’t want to lose any money on it. After all, the money looks better in your pocket than it does in the brokerage account’s bank.
With a stop loss order people don’t realize that they may not get filled at the stop loss price. If the downside happens fast and happens large, your stop loss is automatically turned into a market order. If the share price slides under $110 to $105 you will get filled at $105 and not $110.
Such is the law of the jungle called trading. A protective put fits like a hand in a glove in this jungle. Your $100 stock is now $120, right? A protective put can lock up a hefty profit if you are right and it hits the slippery slope of downhill.
You would buy a protective put with a strike price of $120 and you would go out time wise to two months. The probable protective put price would be $600.
Going out to expiration, the issue actually drops to $110 as you thought. You are looking like a genius and that is a good thing.
Subtract the $110 share price from the $120 protective put strike price and you now have a $10 in-the-money contract. This protective put is worth $1,000.
Subtracting the $600 you paid for the protective put leaves you a tidy $400 profit. You are up $1000 on the stock and $400 on the protective put. That is a total of $1400 assuming you sold both positions.
I realize this all sounds good and like a strategy that should be employed on every trade. Remember, no strategy is perfect at all times. The reason is the stock may not have dropped in price at all before your option expired.
If that had happened you would have lost your $600 option price. On the other hand you would not have entertained a protective put if you didn’t think the stock was headed downwards.
A protective put has its place just like a stop loss order. The trick is in determining where a protective put makes more sense than a stop loss order and where you’ll maximize your efforts in doing so.
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