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Protective Puts - Introduction
Do you wish to buy "insurance" for your stocks to prevent their values from dropping?
Yes, you can with a simple options strategy called "Protective Put"!
Protective Puts is an option trading hedging strategy used
to hedge against a drop in stock price.
Protective Puts are very similar to Married Puts and is a popular option trading strategy amongst stock traders.
Protective Puts protect your stock's unrealised profits, so that you don't have to sell any shares to lock in the profits so far.
Without stock options, the only way a stock trader can protect unrealised profits on shares is to liquidate (sell)
a part of the holding. However, liquidating part of the holding denies the stock trader access to future profits should
the stock continue to do well. Option trading solves this dilemma using Protective Puts.
Protective Puts - How It Works
Imagine this, if a stock trader could "buy an insurance" on his shares at it's present price such that if it drops below the present price, the "insurance"
would compensate the reduction in the stock price 100%, wouldn't that help all stock traders hold on to their stocks longer and reap more future
profits? Wouldn't that help reduce risk dramatically? This is where the Protective Puts option trading strategy come in.
Protective Puts is simply buying at the money put options
whenever you wish to "lock in" your share's profits. Once the Protective Put is in place,
the put options will appreciate in step with any depreciation in the stock price, hedging against any losses completely.
Protective Put Example :
Assuming you own 100 shares of XYZ at $40 and it appreciated to $60. Now, the only way you can guarantee that $60-$40 = $20 profit
is by selling your shares, right?
Now, if you sell your shares, what if the price of XYZ continues to go higher? Won't you have missed out on the profits? This
is when you can simply buy 1 contract of XYZ $60 strike price put options in order to buy "insurance" for your XYZ stock at $60!
Assuming XYZ company got hit by an unforeseen scandal and its stock price drops from $60 to $10. Even though you would lose $60 - $10 = $50 x 100 shares = $5000,
your put options value would actually rise to $60 - $10 = $50, making you a $50 x 100 = $5000 profit, completely offsetting the $5000
loss on the stocks, thereby insuring you against the loss and protecting the value of your portfolio.
Protective Puts - What It Cost
Now, put options are not free. Put options comes at a fraction of the price of the stock, known as a "Premium". You pay a premium for insurance even if it is not used, right? That's exactly the same for Protective Puts. You pay the premium on the put
options exactly as you would pay an insurance premium. If the price of the underlying stock continues to rise, the put options expires
out of the money eventually when its "contract period" is over, incurring the
cost of the put options as expense, exactly like an insurance plan.
How much is the "premium" on a put option? For instance, GOOG (Google Inc.) closed at $823.31 (27 Jan 2017) and its January $822.50 put options are trading
at about $13.00, which is only 1.58% of the value of the GOOG stock itself. So, just paying 1.58% of the value of the stock buys you
complete protection against GOOG dropping below $822.50 for a month! In fact, if you could take a bit of risk, buying the protective put
at the $800 strike price only cost about $6, which is only 0.7% of the value of GOOG's stock! A small fee for a huge protection!
You could also create the same profit/loss profile as Protective Puts using only a fraction of the money involved in the Protective Puts by using
another option trading strategy known as the Fiduciary Calls.
This means that Protective Puts actually creates synthetic long call positions.
But this won't work if you are really using Protective puts in order to protect your stocks.
When To Use Protective Puts?
You would use Protective Puts whenever your stocks have risen to the point where it's profits must be protected.
How To Use Protective Puts?
Protective Puts is a simple option trading strategy where you simply buy to open 1 contract of at the money put options for every 100 shares that you own.
What if you own less than 100 shares of the underlying stock?
Good news is, there are now Mini Options on most of the most heavily traded stocks that represent only 10 shares instead of 100 shares. So
if you own just 10 shares of the underlying stock, even if its slightly lesser than 10 shares, you could simply buy 1 contract of its
Mini put options instead.
What if you owned quite a few different stocks instead?
Well, if you own quite a few different stocks in a single portfolio, you could actually try to hedge the portfolio as a whole by
buying put options on the ETF that most closely represent your portfolio, be it QQQ for Nasdaq, DIA for the Dow or SPY for the S&P500.
Trading Level Required For Protective Put
A Level 1 options trading account that allows the execution of Covered Call and Protective Put is needed. Read more about Options Account Trading Levels.
Profit Potential of Protective Puts :
Protective Puts is an option trading hedging strategy which, combined with the underlying stock, grants unlimited maximum profit as long as the underlying
stock continues to rise.
Profit Calculation of Protective Puts :
The cost of the Put Options are expensed against the rise in price of the underlying stock when calculating profits.
Profit = (stock price - put strike price - cost of put) x number of shares
Following up from the above example:
Assuming XYZ rises to $60 by the expiration of the Put options. Assuming the put options cost $1.00
Profit = ($60 - $40 - $1) x 100 = $1900
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Risk / Reward of Protective Puts:
Upside Maximum Profit: Unlimited
Maximum Loss: Limited
Break Even Point of Protective Puts:
Because you incur a cost on the put options, the underlying stock needs to rise to cover that cost. The breakeven
point is the point beyond which the Protective Puts position would start to profit.
Breakeven = Initial stock price + cost of put options bought.
Following up from the above example:
Breakeven = $50 + $0.80 = $50.80
Advantages Of Protective Puts:
Allows you to hold on to your stocks while insuring against any losses.
Allows you to quickly transform the position into a Synthetic Straddle in order to profit from both up and down moves.
Disadvantages Of Protective Puts:
Cost of the put options eats into profit margin.
Alternate Actions for Protective Puts Before Expiration :
1. If the underlying stock continues to rally strongly, one could sell the
out of the money put options and then buy at the money put
options in order to re-establish the Protective Puts position at the higher price.
2. If the underlying stock drops strongly, one should continue to hold the Protective Puts position all the way to expiration.
Alternate Actions for Protective Puts During Expiration :
1. During expiration, if the put options are in the money
due to a drop in the underlying stock, you could sell the put options on expiration day and then use the profits made to buy more of the underlying stock
in preparation for a rebound, effectively compounding your profits.
2. During expiration, if the put options are out of the money due to the underlying stock rising, one should simply let the put options
expire worthless rather than incurring costs by selling them.
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