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.
Recommended: How to Trade Options: A Beginner’s Guide
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.
Recommended: How to Sell Options for Premiums
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.
Looking to invest? With the SoFi Invest® investment app, investors can choose to actively invest by trading stocks, ETFs, crypto, and more, or take a more hands-off approach with automated investing that’s based on your personal goals and risk tolerance.
Photo credit: iStock/igoriss
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected] Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.