Options contracts are a great way to make short-term gains using the price movements of a stock. That said, they’re considerably riskier than regular equity investments. But then, the risk that you take when you deal with the options contracts of stocks can be managed to a large extent. One way to do that would be to employ options trading strategies like the protective put strategy. If you’re wondering what it entails, here’s everything that you should know about the protective put option strategy.
What is a protective put?
A protective put is an options strategy that is designed to help you limit your losses in the event of adverse and unexpected market movements. This options strategy requires you to buy put options contracts of the stock you currently own. This way, you can limit or sometimes even negate the losses that you might incur when the price of the stock you own goes down.
When should you use the protective put option strategy?
Since the movement of the stock market can be quite unpredictable at times, you might want to hedge against the possibility of downsides in the price of the stock that you are bullish on. This is where the strategy comes into play. The protective put strategy should be used only when you are long on a stock.
How does the protective put work?
For instance, let’s assume that you just bought the stock of a company. You have a bullish view of this stock, which means that you expect the price of the stock to rise in the future. But, you’re not too sure whether the price would actually witness a rise and so you wish to protect yourself from losses.
What do you do in this situation? You seek the help of derivatives, more specifically put option contracts. A put option contract is inherently bearish and expects the price of a stock to fall in the future. And so, when the price of the stock does fall, the put option contract gains in value.
Now, let’s get back to our example. Assume that you also buy a put option contract of the stock that you own to limit your losses. Then what? There are two scenarios that are likely to happen. Let’s delve a little deeper into these two.
Scenario 1: The price of the stock goes up
In this scenario, your long position on the stock starts to generate gains for you. On the other hand, the put option contract that you bought to hedge yourself against risk starts to decline in value. Since you’ve bought a put option, the maximum loss that you get to suffer is just the premium that you paid to buy the option. The net amount that you receive after subtracting the put option premium from the gains of the long position would ultimately be your profit.
Scenario 2: The price of the stock falls
In this scenario, your long position on the stock starts to decline in value. Conversely, the value of your put option starts to rise dramatically. Since you’ve bought a put option, there’s absolutely no cap on the number of gains that you get to enjoy; it is virtually unlimited. Now, the gains from the put option would effectively set off the losses that you experience from the declining long position. Sometimes, you might even end up with a profit too.
Protective put strategy: An example
Let’s now take up a hypothetical scenario to better understand the protective put option strategy.
Assume that you just bought 100 shares of Infosys at Rs. 800 per share. You’re expecting the price to rise, but you also want to protect yourself from downsides. And so, you buy a put option contract with a strike price that’s closest to yours. Here, since you’ve bought the stock at Rs. 800, you also buy a put option contract at the same strike price of 800 for a premium of Rs. 200 per share. The lot size of the contract is also the same at 100 shares.
Now, after you’ve employed the protective put strategy, the stock price rises from Rs. 800 to Rs. 850. Since the price has risen, the put option would obviously decline in value. Let’s say that it is reduced to Rs. 175 per share. At this juncture, your total profit would be Rs. 2,500 [(Rs. 50 x 100 shares) – (Rs. 25 x 100 shares)].
Conversely, if the stock price fell down to Rs. 750, the put option would increase in value, right? Let’s say that it increases to Rs. 250 per share. And so, in this situation, your profit would be Rs. 0 [(Rs. 50 x 100 shares) – (Rs. 50 x 100 shares)]. You would end up in a no-profit and no-loss situation, which is infinitely better than a loss.
As you can clearly see from the above examples, the protective put option strategy is a really good way to protect yourself from uncertainties and market downsides. That said, here’s a point to note. In order for the protective put strategy to work accurately, it is best if you buy the put option around the same time as you buy the stock. This would help keep the differences in pricing to a minimum.