A protective put is a risk management method that investors use to protect themselves against losing ownership of a stock or asset. The hedging method entails an investor purchasing a put option in exchange for a premium.
Puts on their own are a defeatist strategy in which the trader expects the asset’s price will fall in the future. On the other hand, a protective put is often utilised when an investor remains bullish on a company but wishes to hedge against possible losses and uncertainties.
Protective puts can be purchased on stocks, currencies, commodities, and indices to provide downside protection. A protective put is similar to an insurance policy in that it provides downside protection if the asset’s price decreases.
How is a Protective Put Executed?
Generally, an investor who owns stock risks losing money if the stock price falls below the purchase price. You can limit or cap your stock’s losses by purchasing a put option. Protective puts are frequently used by investors who are long or who purchase shares of stock or other assets for their portfolio.
The protective put establishes a known floor price below which the investor will not lose additional money when the underlying asset’s price falls.
A put option affords the holder the right to sell a defined quantity of the underlying securities at a predetermined rate before or on a specified date. Unlike futures contracts, options contracts do not force the holder to sell the underlying asset but rather allow them to do so if they want. The contract’s fixed price is referred to as the strike price, and the defined date is referred to as the expiry date or expiry. A single option contract represents one hundred shares of the underlying asset.
Additionally, as with everything else in life, put options are not free. The premium is the cost of an option contract. This price is determined by numerous factors, including the underlying asset’s current price, the time remaining to expiration, and the asset’s implied volatility (IV)—how likely the price will move.
Premiums and Strike Prices
At any time, a protective put option contract can be purchased. Confident investors will purchase these at the same time as the stock. Others may decide to hold off and purchase the contract later. When they purchase the option, the link between the underlying asset’s price and the strike price might place the contract into three moneyness categories. Among these categories are the following:
- At-the-money (ATM) contracts are those in which the strike and market prices are equal.
- Out-of-the-money (OTM) options have a strike price that is less than the market price.
- In-the-money (ITM) options have a strike price that is more than the market price.
Investors seeking to hedge their holdings’ losses focus primarily on the ATM and OTM option options.
If the asset’s price and the strike price are the same, the contract is considered at-the-money (ATM). An investor who purchases an at-the-money put option has 100 per cent protection until the option expires. Often, a defensive put will be at-the-money if acquired concurrently with the underlying asset.
Additionally, an investor may purchase an out-of-the-money (OTM) put option. Out-of-the-money options are those whose strike price is less than the current price of the underlying stock or asset. An out-of-the-money put option does not offer complete downside protection but limits losses to the difference between the acquired stock price and the strike price. Investors utilise out-of-the-money options to reduce the premium cost because they are willing to accept a certain level of risk. Additionally, the premium will decrease when the strike price is below the market value.
Options come in various strike prices and expiration periods, allowing investors to tailor their protection—and their premium fee—to their specific needs. For instance, an investor may decide that they cannot accept losses of more than a 5% decrease in the stock price. An investor might purchase a put option with a strike price that is 5% lower than the stock price, resulting in a 5% loss if the stock decreases.
Possibilities with Protective Puts
A protective put limits downside losses while keeping unlimited upside potential gains. However, the approach necessitates a long position in the underlying stock. If the stock continues to rise, the extended stock position benefits and the acquired put option expires worthless. The only thing that is lost is the premium paid to purchase the put option. When the initial put expires, the investor will purchase another protective put to safeguard their assets.
Protective puts can cover a portion or all of an investor’s long position. When the ratio of protective put coverage to long stock is equal, the technique is a married put.
Married puts are frequently employed by investors who wish to purchase a stock and immediately purchase a put to hedge the position. However, an investor may purchase a protective put option at any moment while still owning the underlying stock.
A protective put strategy’s maximum loss is restricted to the cost of the underlying stock minus any commissions, less the put option’s strike price plus any premium and commissions paid to buy the option.
The put’s strike price acts as a stop-loss level for the underlying stock. The best-case scenario is that the stock price grows significantly since the investor benefits from the long stock position in a protective put. In this situation, the put option expires worthless, the investor pays the premium, but the stock appreciates.
This article should give you a good idea about a protective put and what is a protective put!