Protective Put

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What is a protective put?

A protective put is a risk management strategy using option contracts that investors use to protect themselves against the loss of possession of a share or an asset. The hedging strategy involves an investor buying a put option for a fee, called a premium.

The bets themselves are a bearish strategy where the trader thinks that the price of the asset will fall in the future. However, a protective put is generally used when an investor is still optimistic about a stock but wants to hedge against potential losses and uncertainty.

Protective put options can be placed on stocks, currencies, commodities and indices and provide some downside protection. A protective put acts like an insurance policy by offering downward protection in the event of a fall in the price of the asset.

Key points to remember

  • A protective put is a risk management strategy using option contracts that investors use to protect themselves against the loss of a stock or other asset.
  • For the cost of the premium, the protective put acts like an insurance policy by offering protection against falling prices of an asset.
  • Protective put offers unlimited earning potential since the put buyer also owns shares of the underlying asset.
  • When a protective put covers the entire long position of the underlying, it is called a married put.

How a protective put works

Protective put options are commonly used when an investor is a long-term buyer or buys stocks or other assets that he intends to hold in his portfolio. Typically, an investor who owns shares risks losing out on the investment if the stock price drops below the purchase price. By purchasing a put option, any loss on the stock is limited or capped.

The protective put fixes a known floor price below which the investor will not continue to lose additional money even if the price of the underlying asset continues to fall.

A put option is a contract that gives the owner the opportunity to sell a specific amount of the underlying security at a fixed price before or before a specified date. Unlike futures contracts, the option contract does not oblige the holder to sell the asset and only allows him to sell if he wishes. The fixed price of the contract is known as the strike price, and the specified date is the expiration or expiration date. An option contract is equivalent to 100 shares of the underlying asset.

In addition, as with everything in life, put options are not free. The costs of an option contract are known as the premium. This price is based on several factors, including the current price of the underlying asset, the time to maturity, and the implied volatility (IV) – the probability that the price will change – of the asset.

Strike prices and bonuses

A protection put option contract can be purchased at any time. Some investors will buy them at the same time and when buying the shares. Others may wait and buy the contract at a later date. Each time they buy the option, the relationship between the price of the underlying asset and the strike price can place the contract in one of three categories, known as money. These categories include:

  1. At-the-money (ATM) where strike and market are equal
  2. Out-of-the-money (OTM) where the strike is below the market
  3. In-the-money (ITM) where the strike is above the market

Investors looking to cover the losses of a stake mainly focus on the ATM and OTM option offerings.

If the asset price and the exercise price are identical, the contract is considered to be money (ATM). A put option puts 100% protection on the investor until the option expires. Many times, a protective put will be in the money if it was purchased at the same time as the underlying asset is purchased.

An investor can also buy an out-of-the-money put option (OTM). Out of stock occurs when the strike price is lower than the share or asset price. An OTM put option does not provide 100% downside protection, but rather caps losses at the difference between the price of the shares purchased and the strike price. Investors use out-of-the-money options to reduce the cost of the premium because they are prepared to incur a certain loss. In addition, the lower the strike, the lower the premium.

For example, an investor could determine that he is not willing to incur losses beyond a 5% drop in the stock. An investor could buy a put option with an exercise price 5% lower during the share, thus creating the worst scenario of loss of 5% if the share goes down. Different exercise prices and expiration dates are available for options, offering investors the flexibility to adjust coverage and premium fees.

Important

A protective put is also known as a married put when option contracts are matched one for one with shares held.

Potential scenarios with protections

A protective put keeps losses down limited while preserving unlimited potential gains up. However, the strategy is to be the underlying stock for a long time. If the stock continues to rise, the long position in the stock benefits and the put option purchased is not necessary and will expire worthless. All that will be lost is the premium paid to buy the put option. In this scenario where the original put has expired, the investor will buy another protection put, again protecting his assets.

Protective put options can cover part of an investor’s long position or all of its assets. When the protection put coverage ratio is equal to the amount of long stock, the strategy is known as a married put.

Couples put options are commonly used when investors want to buy a stock and immediately buy the put option to protect the position. However, an investor can buy the protective put option at any time as long as he owns the shares.

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The maximum loss of a protective sales strategy is limited to the purchase cost of the underlying stock, as well as the commissions, minus the exercise price of the put option plus the premium and the commissions paid. to buy the option.

The exercise price of the put option acts as a barrier to stop losses in the underlying stocks. The ideal situation in a protective put is that the share price increases significantly, as the investor would benefit from the long position in the shares. In this case, the put option will expire worthless, the investor will have paid the premium, but the security will have increased in value.

Benefits

  • Put options offer downside protection against falling asset prices for the cost of the premium.

  • Protective puts allow investors to remain a security offering potential for gains for a long time.

The inconvenients

  • If an investor buys a put and the share price goes up, the cost of the premium reduces the profits on the trade.

  • If the stock goes down in price and a put has been bought, the premium is added to the losses on the trade.

Real example of a protective put

Let’s say an investor bought 100 shares of General Electric Company (GE) for $ 10 a share. The share price has risen to $ 20, giving the investor $ 10 per share of unrealized gains – unrealized as they have not yet been sold.

The investor does not wish to sell his GE assets, as the stock could appreciate further. They also don’t want to lose the $ 10 in unrealized winnings. The investor can buy a put option for the security to protect part of the gains as long as the option contract is in effect.

The investor buys a put with an exercise price of $ 15 for 75 cents, which creates a worse scenario for selling the stock for $ 15 per share. The put option expires in three months. If the stock falls to $ 10 or less, the investor wins on the put option starting at $ 15 and less on a dollar for dollar basis. In short, anywhere below $ 15, the investor is covered until the option expires.

The cost of the option premium is $ 75 ($ 0.75 x 100 shares). Consequently, the investor blocked a minimum profit equal to $ 425 (exercise price of $ 15 – purchase price of $ 10 = $ 5 – premium of $ 0.75 = $ 4.25 x 100 shares = $ 425).

In other words, if the stock returned to the $ 10 level, the unwinding of the position would generate a profit of $ 4.25 per share, since the investor made $ 5 of profit – the strike of $ 15 minus the original purchase price of $ 10 – minus 0.75 cents. premium.

If the investor did not buy the put option and the security fell to $ 10, there would be no profit. On the other hand, if the investor bought the put and the share reached $ 30 per share, there would be a gain of $ 20 on the transaction. The gain of $ 20 per share would pay the investor $ 2,000 ($ 30 – $ 10 initial purchase x 100 shares = $ 2,000). The investor must then deduct the premium of $ 75 paid for the option and leave with a net profit of $ 1,925.

Of course, the investor will also have to take into account the commission he paid for the initial order and the costs incurred when selling his shares. For the cost of the premium, the investor protected part of the profits from the transaction until the expiration of the option while being able to participate in further price increases.

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