The so-called “protective put” strategy is a common method of protecting one portfolio from downturns. To accomplish this, investors purchase put options on companies they already own in order to protect their downside. If properly performed, protective puts provide tax advantages and the possibility to profit from your positions' ongoing uptrend.
An insurance-type approach
A protected put approach is similar to insurance in essence. The primary objective of a protective put is to prevent potential losses caused by an unexpected decline in the underlying asset's price.
Adopting such a plan does not impose an absolute cap on the investor's prospective gains. The profitability of the plan is defined by the asset's growth potential. The premium paid for the put, however, reduces profits.
Conversely, the protective put technique does restrict the greatest potential loss, since any losses in the long stock position below the strike price of the put option are offset by profits in the option. Bullish investors who wish to hedge their long positions in an asset generally adopt the protective put technique.
Illustration of a Protective Put
Let's assume that one investor owns 1,000 shares of a particular corporation, each of which is priced at $20. Even though he anticipates that the price of his shares will rise in the future, he want to hedge against the possibility of an unforeseen decrease. Consequently, he chooses to buy one protective put contract with a strike price of $20. The protected put has a price of $10.
The payout from the protective put is contingent on the future share price of the corporation. The subsequent possibilities are feasible:
1. Share price exceeds $25.
If the share price rises above $25, he will incur an unrealized profit. Current Share Price – $25 yields the profit calculation (it includes initial share price plus put premium). Thus, the put option will not be exercised.
2. Share prices range between $20 and $25.
In this situation, the share price will either remain unchanged or grow little. However, he will still lose money or at most reach the point of breakeven. In fact, the little loss is a result of the premium he paid for the put option. As in the prior instance, the put option will not be executed.
3. Share price falls below $20.
In this situation, he will be able to limit his losses by exercising the protective put option. After exercising the put, he will sell his 1,000 shares at $20 a share. Therefore, his loss will be restricted to the cost of the protective put premium.
The Benefits of a Protective Put Strategy
If an investor owns a substantial amount of a certain stock and purchases a protective put option on it, it makes no difference if the stock falls 80%; his losses are limited to the strike price plus the cost of the option.
Suppose an investor reaped the benefits of the entire upside potential of a particular company and now holds a multi-million-dollar stake. Liquidating it would incur large taxes and retaining the position could be exposed to significant volatility based on a number of variables. Purchasing protective puts would be an option in this situation, as it would safeguard his position.
Cons of a Defensive Put Strategy
Pricing of Options
Options are sometimes viewed as costly relative to the underlying stock's actual volatility since they provide so much upside potential with so little risk.
Ineffective During Economic Downturns
When the market has already begun to decrease, it is often unadvisable to acquire protective puts. Indeed, by that time, options are often excessively expensive, and equities are closer to the desired strike prices.
If an investor purchases protective puts on a stock and the stock ends up stagnating, he will lose the option premium and realize no profit from the underlying security. If this happens often enough, the associated financial losses could be substantial.
In the very same way that protective puts are utilized to hedge a long position, protective calls may come in handy to defend against short squeezes.
Indeed, the protective call is utilized when an investor has a profitable open short position – he is protected if the relevant stock begins to grow in price, since the value of his call options will also increase. Therefore, if the stock begins to increase, he may exercise his option to purchase it, which he could then use to settle his short stock position, or he could sell his call options for a profit and keep his stock position open.
As seen, options play a significant role in hedging investors' holdings. Without options, a trader who wished to safeguard profits on an open position would be forced to close the position, perhaps missing out on more profits if the stock continued to rise.
Protective Puts, In Summary
Protective puts are a smart technique to plan for a potential downturn and give an alternative to the typical approach of selling shares. Trading options in general requires a higher degree of skill than trading stock alone, but options trading may provide you with additional flexibility, tax advantages, and enhanced capital efficiency.
Hence, protective puts may be a sound investment strategy to take into consideration when stock markets are quiet, but you still want to protect yourself from losses, keep your profits, and put off paying taxes. Bear in mind, however, that this strategy will cut into your profits if a positive surge occurs in the stock market.