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Protective Puts - Introduction
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.
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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.
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, incurring the
cost of the put options as expense.
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.
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.
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Example : Assuming you bought 100 shares of QQQQ at $40 on 1 Jan. QQQQ rallies to $50 within a few days and you wish to hold on for future appreciation
without risking a short term correction.
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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.
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Folllowing Up On The Previous Example : To seal in that $50 value, you would buy to open
1 contract (equivalent to 100 shares) of $50 Put Options expiring a few months later (e.g March50Put for $0.80).
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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 QQQQ rises to $60 by the expiration of the March50Put.
Profit = ($60 - $50 - $0.80) x 100 = $920
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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
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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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