Introduction To Protective Put
A protective put is a trade that involves the buying of an at the money put option while already owning shares in the underlying stock. For every 100 shares already , an at the money put option is bought as well. The married put and the protective put have the same risk and reward profiles.
Married put vs protective put
In a married put strategy, the buying of the underlying security occurs at the same time as the buying of the put option. In a protective put strategy, the investor buys put options added to an already long position of the underlying security.
Steps
Step 1: Perform economic, fundamental and technical analysis
Step 2: Outlook – Bullish
Step 3: Study the option chain
Step 4: Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6: Limited loss and risk
Step 7: Loss calculation on protective put
Step 8: Potential for unlimited profit
Step 9: Profit calculation on protective put
Step 10: Calculate Risk & Reward Ratio
Step 11: Set Up Trade: Executing a protective put strategy
Step 12: Exit Trade
Step 13: Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Perform an examination of the economy and the fundamentals of the underlying security. Fundamental analysis will help a trader to put a value on the underlying security. Perhaps, the underlying security is trading at a price that is lower than its intrinsic value. The trader should also use technical analysis to get optimal entry and exit points. Some chart patterns that options traders should look out for are:
Read: Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2: Outlook – Bullish
The investor uses a protective put strategy when they are bullish on the underlying security in the long term but is uncertain of short term price movements that will negatively affect the trade and indirectly, his entire investment portfolio. He buys puts to hedge against declines in the price of the underlying security. Essentially, he is buying insurance on his stock positions.
Step 3: Study the option chain
Examine the options chain. Select put options of a particular strike price to protect the value of the long position.
Read: Learn to read and understand options chain
Step 4: Breakeven Analysis
There is one breakeven point in an underlying security.
The breakeven price point is : Acquired price of the underlying security + premium paid for put
Step 5: Understand Your Profit Zones
After calculating the breakeven point, the options trader should be able to identify the profit zone on the payoff diagram. The profit zone is any price point above the breakeven point.
Step 6: Limited loss and risk
The loss is limited to the sum of the premium paid for the put and the commissions paid to the broker. The maximum loss occurs when the price of the underlying security is less than or equal to the exercise price of the bought put.
Step 7: Loss calculation on protective put
The loss can be calculated as:
Premiums paid for put + commissions paid to broker
Step 8: Potential for unlimited profit
The price of the underlying security can theoretically go up to infinity. Therefore, the potential for profit is unlimited when an investor uses a protective put. As the price goes up, the total value of the positions will increase as well. An investor earns a profit when the price of the underlying security is greater than the sum of the acquisition price of the underlying security + premiums paid for the put
Step 9: Profit calculation on protective put
This is how an investor using a married put should calculate profit :
Price of the underlying security – acquired price of underlying security – premiums paid for put
Step 10: Calculate Risk & Reward Ratio
A trader may be able to estimate the potential target exit price. Hence, in that case, he is able to calculate the risk and reward ratio of the protective put strategy. The risk and reward ratio should be attractive relative to other trades.
Read more: Understanding Risk/Reward Ratio For Option Traders
Step 11: Set Up Trade: Executing a protective put strategy
- Buy 1 ATM put option
- Long 100 shares of the underlying security
Step 12: Exit Trade
Once there is a reasonable profit, the trader should consider exiting the position.
Step 13: Record Trade In Diary
Last but not least, record the trade in a diary. Use it as a tool for comparison, analysis and reflection. The trader should also improve on his personal trading algorithm over time to become a better options trader.
Example Of A Protective Put
ABC company is trading at a price of $30. You own 100 shares at a purchase price of $32 and you see that the price may drop due to certain negative news to $23. However, you are still bullish on the long term prospects of the company as its fundamentals are sound. It’s free cash flow has increased and you foresee a possible hike in dividends by the management of the company. You decide to buy July 30 put to hedge against the possible decline of the underlying to $23 and pay $2 for the put option.
| Price of underlying security | Cost of the put option | Value of put option on expiry | Value of the trade(Price of stock + value of put) |
| $28 | $2 | $2 | $28 |
| $25 | $2 | $5 | $28 |
| $20 | $2 | $10 | $28 |
As you can see from the above table, the long put helps to hedge against a downside in stock prices.
If the price of the underlying security rises to $40, a profit is achieved because the price of the stock is greater than the sum of the option premium paid and the acquired price of the stock.
At a price of $40, the put option will expire worthless on expiry date. But the realisable profit per share is : $40 – $32 – $2 = $6
$6 x 100 = $600
The investor could realise a profit of $600 on liquidation of the trade when the price of the stock is $40.
Comparable options trading strategies
The long call and married put have a very similar payoff profile to the protective put.