Few things are as beautiful as learning new ideas. Some traders would add especially when it’s a stock that gets temporary protection thanks to a put option, creating the “protective put.” Of all the benefits that a protective put strategy can provide, perhaps the biggest one is that it lets you sleep better at night, knowing that your stock position is protected from a major, or even catastrophic, loss.
This is perhaps the most widely understood benefit of the protective put strategy, although there’s another benefit as well. But first, what is a protective put?
The simple definition: it’s a long put option and long stock, where “long” means you own both. This is done in a ratio of one put for every 100 shares of stock. For instance, if you own 100 shares of XYZ, Inc., and shares are trading at $100, buying one 90-strike put for, let’s say, $1.50, creates a protective put position. You could either buy the put and the stock together as one trade, or assemble the position over time.
Into the Hedges with the Bears
Buying a put option is considered a bearish trade because the option price rises when the underlying stock drops. But when paired with a stock position, the put is considered a hedge. Traders may consider buying a put that’s out of the money (OTM), meaning its strike price is less than the stock price, to help keep the cost low.
In our example with the $100 stock and the 90-strike put, you’re not buying that put and hoping your stock tanks. You want your stock to go up. You’re buying the puts “just in case.”
In case of what? In case of anything that can drive XYZ below $90. For example, let’s say XYZ is a pharmaceutical company and the FDA is going to rule on the company’s promising new drug. A thumbs-up could send the stock higher, and since the maximum loss of the put is the purchase price, as long as XYZ goes up by more than that amount, it’s a profitable position.
A thumbs-down, however, could send the stock tumbling, and this is where the hedge comes into play. Since the put gives you the right, but not the obligation, to sell XYZ at $90 if you want to, you’re locking in a sale price. You get all the glory (and profit) if XYZ goes up. But if it doesn’t, the worst you can do is take a $10 loss and transaction costs for both ($100 stock price minus $90 put option strike), plus the $1.50 option premium, for a maximum possible loss of $11.50. Below $90, any stock loss is offset dollar for dollar by the put, as you can see in table 1.
|P/L of stock bought at $100||-$30||-$10||$0||+$10||+$30|
|P/L of 90 put bought at $1.50||+$18.50||-$1.50||-$1.50||-$1.50||-$1.50|
Table 1. Individual profit/loss figures for both the stock and the option at expiration, and the net P/L of both positions. For illustrative purposes only. Past performance does not guarantee future results.The above table does not include transaction costs.
A different scenario might be the release of XYZ’s earnings report. Or maybe a stock has had a good run and you simply want to lock in some of that profit without having to sell the stock.
Option Pricing: The Role of Volatility
Volatility can play a major role in the cost of an option, especially when a potentially large move might be at hand (like with the FDA and earnings scenarios). If everyone thinks a stock may have a big move, in either direction, this can drive up the cost of all options. You’ll have to decide for yourself if the cost has become prohibitively expensive.
Outside of the periodic FDA or earnings announcement, is it worthwhile to always have a protective put in place? That depends on your penchant for risk. Some stocks remain range-bound for years, and in such a case, the cost might be too high.
This brings us back to the second benefit of protective puts: locking in profits as a stock moves higher. Think of the put option as providing a floor beneath a stock. As the stock goes higher, you can sell the current put option and buy another put option with a higher strike price, raising the floor. Depending on your strike selection and stock movement, it’s possible to lock in profits as the stock continues to appreciate. Of course, every step of the way you would be paying for the puts and the transaction costs, and keep in mind each of these unused puts will expire.
With protection from major losses and the ability to lock in profits, it isn’t hard to see why some traders use puts for risk management.
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