Protective puts are one way to hedge stocks against a significant price drop. But investors should consider factors such as time decay and volatility.
You likely have some stocks in your portfolio that you don’t want to sell. Is there a way to temporarily protect those stocks from sharp price drops? Although there are different ways to hedge positions in the stock market, one way is to buy a put option contract on a stock you own. This strategy, known as a “protective put,” is a potential solution to help limit your downside risks but isn’t without its own downsides.
When you buy a put contract, you enter a deal to sell 100 shares (typically) of stock on or before a chosen date at a predetermined price known as a strike price. If the price of the underlying drops significantly, that put option contract will likely gain in value. This could at least partially offset the potential losses in the underlying stock. Note: Because put contracts trade in an open market, they can be freely traded throughout a contract’s life, but the price of an option is subject to high volatility.
Here’s an example: Say you own XYZ stock and it’s trading at $130 per share. You don’t want to sell the stock, but you’re worried about how some potential news may affect its near-term prospects. So, you may elect to buy a put contract. Let’s assume the put contract on XYZ has a strike price of $120 that expires in two months and it trades for $265, or $2.65 per share. If XYZ stock drops to $115 after a month, the put contract may have gone up in value to $750. Although this increase in the put contract’s price doesn’t completely make up for the loss in the 100 shares of stock, it helps reduce the unrealized loss by almost $500, not including transaction costs. If the stock were to drop even more, the “protection” offered by the put option would increase.
For all these examples, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So, an options premium quote of $1 is really $100 per contract.
So, given this temporary protection, why doesn’t every investor buy a protective put on every stock? Well, there are downsides to a protective put. First there’s an initial cost to the put, known as a premium. This premium is the most an investor can lose on the put, but given the high volatility found in options contracts, there’s a strong chance of losing the entire premium. This premium may represent just a fraction of the investment in the underlying stock, but it’s something to carefully consider. If the underlying stock increases rapidly, the loss incurred on the put contract can substantially eat into overall profits, especially if an investor uses the protective put strategy several times.
Another important consideration when buying puts is the role of time decay or theta. Options contracts tend to lose value over time, all else being equal. This time decay may not be obvious if the underlying stock and the options price make a strong move. However, if the underlying stock isn’t moving quickly, the option you bought will likely decline in value. The consequence of time decay: When the stock doesn’t make a significant decline, a protective put will likely cost you significantly. In other words, unless the underlying stock is dropping, there may be considerable costs to holding on to protective puts.
The strike price the put buyer chooses makes a difference here—it will affect the amount of time decay and overall protection the option provides. Put options with a lower strike price will be cheaper to purchase but ultimately offer a lesser amount of protection, particularly on smaller stock price moves. If the strike price is significantly lower than the current stock price, the rate of time decay will be less. On the other hand, investors who want to maximize their protection may elect to buy a put option that’s close to a stock’s current price because it could result in a more expensive option subject to a greater amount of time decay.
Now that you know time decay could work against an option buyer, let’s turn to volatility. Implied volatility (IV) in options contracts may or may not benefit the buyer. A drop in volatility can make profiting from a protective put more difficult, while an increase could help. So, although it might make sense to buy put options before a time of potentially high stock volatility such as earnings, realize that options prices will accordingly be more expensive. And after the uncertainty dies down, options prices will tend to depress because of the accompanying drop in IV.
A protective put can make sense in a portfolio to help protect against a strong stock price drop. However, because of the associated costs of holding a put option, it’s unlikely to be a permanent, repeating addition to a portfolio, where the investor constantly buys new puts each time the old puts expire. Instead, protective puts are generally used in a more targeted fashion. In other words, if there’s a specific situation or time period that warrants this protection, a protective put may make sense for that particular circumstance. But once the situation is over, the protective put can be removed.
Of course, if you’re bearish on a particular stock, it may make the most sense to sell the stock until your outlook changes. After all, risk is part of being in the stock market, and there may be times when you must decide to live with that risk. That said, smartly placed protective puts can be a great way to help manage a stock’s, and sometimes even a portfolio’s risk for a limited time.