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A protective put is a way to lessen the risk of losing money when you own a stock or other asset. If you are worried about the price of your stock going down, you can use a protective put to feel safer. In this strategy, you pay a fee to buy a put option.
Put options are generally used when traders think the asset price will go down. But, a protective put is used when you are hopeful about your stock doing well, yet you want to be cautious against any sudden price drops.
How a protective put works
A protective put is a tool used by investors who have bought shares of a stock or other assets, aiming to keep them for a while. When someone buys a stock, they may lose money if the stock’s price falls below what they paid for it. A protective put helps in limiting this loss.
When an investor buys a put option, it’s like setting a safety net. This net is a price point below which, if the stock’s price falls, the investor won’t lose any more money. This price point is known as the floor price.
In simple terms, a put option is a promise that allows, but doesn’t force, the owner to sell a particular amount of the stock at a fixed price on or before a certain date. This fixed price is called the strike price, and the certain date is the expiration date.
Conceptually, a put option is the same as a protective put. But, the approach behind buying the put option is different for a protective. Here, the buyer does not directly trade in the derivative contract. Instead, this derivative options contract is used as a protection for the bullish approach, where the trader expects the price to rise further but wants to secure the profits already made.
Potential scenario with protective put
A protective put helps keep losses limited while also keeping chances for gains open. It requires owning the stock. If the stock price goes up, the owner benefits, but the put bought is not needed and expires with no value.
The only loss is the money paid for the put. In such cases, the owner can buy another protective put to keep protecting the stock.
Protective puts can cover some or all of an owner’s stocks. When the protective put covers all the stocks owned, it’s called a married put.
A real-world example of a protective put
Consider an investor who bought 100 shares of a company, say Reliance Industries Limited, at ₹2000 per share. The share price then climbs to ₹2500, offering the investor ₹500 per share in unrealized gains—unrealized because the shares have not been sold yet.
The investor wishes to hold onto their Reliance shares, anticipating further price appreciation. However, he also wants to safeguard the ₹500 per share unrealized gain.
Hence, he buys a put option contract with a strike price of ₹2,500. So, even if the price falls,
he has the option to sell it at ₹2,500 to retain his initial profits.
When should you use a protective put strategy?
Employing a protective put strategy is akin to having insurance. The core aim is to curtail losses that might occur from a sudden price drop of the underlying asset. Even if a trader has a bullish outlook in the long term, a protective put can help lessen the risk from unforeseen price swings in the short term.
The success or failure of this strategy hinges on the price movement of the underlying asset. Nonetheless, the premium paid to buy the option augments the total cost of a protective put.
Pros and cons of protective put
A protective put strategy holds a favourable risk-to-reward ratio. The potential to earn a profit is unlimited while the risk is capped. Profits are generated from the difference between the sale price and the strike price of the underlying asset, less the premium paid.
A profit occurs when the underlying asset’s price is higher than its sale price. The maximum loss in a protective put is the amount paid for the put option’s premium. Loss happens when the price movement doesn’t match the trader’s forecast at the trade’s inception.
If the underlying asset’s price is higher than the put option’s strike price, a loss results.
Conclusion
A protective put is a strategy used by bullish traders. While a put option is often bought by traders with a bearish approach, expecting prices to fall, a protective put is slightly different. Bullish traders who expect prices to rise but want to cover themselves for possible losses use this strategy.
A protective put acts like a safety net if the trade doesn’t go as expected. The losses are small, but the profits can be significant. This strategy yields best when well-researched.
FAQs
A protective put hedging strategy revolves around buying put options to cover up for potential losses when the stock’s price falls. If the stock’s price falls against the trader’s expectation, the put option provides the right to sell the stock at a predetermined price, limiting the risk. However, traders must consider the premium involved in buying put options as it will impact the end profit.
Moneyness of options discusses the intrinsic value of an options contract. There are three kinds of moneyness for put options:
At-the-money (ATM) where the price of the stock and strike price are the same.
Out-of-the-money (OTM) where the strike price is less than the price of the stock.
In-the-money (ITM) where the strike price is more than the price of the stock.
Mainly, investors looking to keep losses on a stock limited focus on ATM and OTM options.
No, protective put is not a bearish strategy. It is a hedging strategy used by traders with a bullish approach. They buy stocks expecting the prices to increase. However, they also try to cover themselves for possible losses using the protective put options contract.
You should buy a protective put when you are a bullish trader, but you also expect some uncertainty in price movements. Once you buy a stock, and the price rises as expected, you can lock your profits using a put options contract.
Synthetic trading is a trading methodology where traders enter into certain transactions to mimic the results of another security, however, with some alterations.
The protective put is a synthetic call strategy, where investors buy put options to retain the results of their long positions on a stock.