A protective put is an investment strategy that employs options contracts to mitigate the risk that comes with owning a particular security or commodity. In it, an investor buys a put option on the security or commodity.
Typically, put options are used by investors who hope to benefit from a price decline in a given investment. But in a protective put strategy, the investor owns the underlying asset, and is positioned to benefit if the price of the asset goes up.
Essentially, the investor is buying the right to also make money if the investment goes down. But while this protection is a nice thing to have, it isn’t free.
To buy the option, the investor pays a fee, called a premium. It is a way of managing uncertainty and risk (sort of like an insurance policy). An investor may take out a protective put on anything they own, including equities, currencies, commodities like oil, and index funds. But if the investment they own does go up, the investor will have to deduct the cost of the put-option premiums from their returns.
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Understanding Protective Puts
Investors typically purchase protective puts on assets that they already own as a way of limiting or capping any future potential losses.
The instrument that makes a protective put strategy works is the put option. A put option is a contract between two investors. The buyer of the put acquires the right to sell an agreed-upon amount of a given asset security at a given price during a predetermined time period.
Important Options Terms to Know
There is some key options trading lingo to know, in order to fully understand a protective put.
• The price at which the purchaser of the put option can sell the underlying asset is known as the “strike price”.
• The amount of money the buyer pays to acquire this right is called the “premium”.
• And the end of the time period specified in the options contract is the expiration date, or “expiry date”.
• The strike price is also known as the “floor price”, after which the investor will not face losses on their investment. The options allow the investor to sell the underlying asset at the floor price, no matter where it is trading, which serves the purpose of wiping out the losses the investor would face below the strike price.
For complete coverage in a protective put strategy, an investor might buy put options contracts equal to their entire position. For large positions in a given stock, that can be expensive. And whether or not that protection comes in handy, the put options themselves regularly expire — which means the investor has to purchase new put options contracts on a regular basis.
How Strike Price and Premiums Affect Protective Puts
An investor can buy a protective put option contract when they buy the underlying security, or at any time while they’re holding it. But whenever they buy the put option, that option’s strike price will bear one of three relationships to the security they own.
These three relationships between a security’s price and the price of a given option are sometimes called the “moneyness.” The varieties of moneyness are:
1. At the money (ATM): This is when the option’s strike price and the asset’s market price are the same. An option purchased ATM will offer 100% protection against losses for the duration of the option contract.
2. Out of the money (OTM): In this situation, the option’s strike price is lower than the asset’s market price. With an OTM option, the further the strike price is below the market value, the lower the premium. An OTM put option won’t provide complete protection against loss, but it will limit the losses to just the difference between the price at which the investor bought the stock price and the option’s strike price.
3. In the money (ITM): This is when the asset’s market price is lower than the option’s strike price. In this scenario, the option might be worth exercising in order to cover the price of the premium.
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Protective Put Scenarios
An investor who is pursuing a protective put strategy will own the underlying security, commodity, currency or asset. If the underlying asset goes up in value and the put options related to it expire, then the investor gets to keep all of the upside growth, minus the premiums connected with the put options. To keep the protection, the investor will have to buy new put options once the original options expire.
Investors may use protective puts differently. Some investors use the strategy to cover only a portion of a long position. Others may use protective puts for the entirety of their position. When protective put coverage is the same as the amount of stock the investor owns, it is often referred to as “married put.”
Most often, investors will enter into married puts at the time they buy a given stock, though they can enter into a married put at any time they want to protect their investment.
A married ATM put effectively limits the maximum loss an investor faces to the costs connected with buying the stock, including commissions, plus the premium and other costs related to purchasing the put option.
Pros & Cons of Protective Puts
As with most investing strategies, there are both upsides and downsides to using protective puts.
Pros of Protective Puts
Protective puts allow investors to set a limit on how much they stand to lose in a given investment. Here’s why investors are drawn to them:
• Protective puts offer protection from the possibility that an investment will lose money.
• The protective put strategy allows an investor to participate in nearly all of an investment’s upside potential.
• Investors can use at-the-money (ATM), or out-of-the-money (OTM) options, or a mix of the two to tailor their risks and costs.
Recommended: In the Money (ITM) vs Out of the Money (OTM)
Cons of Protective Puts
Like any form of insurance, buying protective put options comes at a cost.
• An investor using protective puts will see lower returns if the underlying stock price rises, because of the premiums paid to buy the put options.
• If a stock doesn’t experience much movement up or down, the investor will see a steady loss of assets as they pay the option premiums.
• Options with strike prices close to the asset’s current market price can be prohibitively expensive.
• More affordable options that are further away from the stock’s current price offer only partial protection and can put the investor in the position of losing money.
Protective put options are risk-management strategies that use options contracts to guard against losses. This options-based strategy allows investors to set a limit on how much they stand to lose in a given investment.
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