Protective Put- The Basics
Protective put is a hedging strategy where the holder of a security buys a put to guard in opposition to a fall in the stock price of that security
. This is also called put hedge. The Protective Put is also known as "puts and stock", "married put", or "bullets." It is an ideal strategy for an investor who wants full hedging coverage for his position. This is where the covered Call Strategy will cover an investor down only as far as the premium he receives, then, the protective put strategy will protect the investor from the break-even point down to zero.
A protective put strategy is normally used when the options trader is still bullish on a stock owned, but suspicious of approaching irregularities. Protective put is intended to protect unrealized gains on shares from previous purchase.
You will find no limit to the maximum profit attainable with the protective put, which is also known as a synthetic long call. Its risk/reward profile is the same as that of a long call's profile.
Here are the formula for calculating profit (excerpts from www.theoptionsguide.com):
"Maximum Profit = Unlimited
"Profit Achieved When Price of Underlying > Purchase Price of Underlying + Premium Paid
"Profit = Price of Underlying - Purchase Price of Underlying - Premium Paid
When to use Protective put?
When you have a long stock and want to protect yourself against a market correction, you surely need the protective put. Protective Put strategy has a very similar pay off profile to the Long Call, whereas the maximum loss is limited to the premium paid for the option. With this, you have an unlimited profit potential.
Potential maximum profit for this strategy will only depend on the potential price increase of the underlying security. Experts say it is unlimited. Once put expires in-the-money, any gains realized from in an increase in its value will offset any decline in the unrealized profits from the underlying shares.
Protective Puts are good for investors, who are very risk averse. They hold stock and are concerned with stock market correction. Once the market sell off rapidly, the value of protective put options that the trader holds increases while the value of the stock decreases. When the combined position is hedged, profits of the put options will offset the losses of the stock. All investors will then loose the premium paid.
If the market rises substantially past the exercise price of the put options, then the protective puts will expire worthless as the stock position increases. Nonetheless, as the loss of the put position is limited, the profits gained from the increase in the stock position become unlimited. In such case, the losses of the put option and the gains form the stock do not offset one another. The gained profits from the increase in the underlying out weight the loss sustained from the protective put option premium.
Protective put is a very important matter to study in the field of trading. If you are into protecting your stocks, make sure that you have a good knowledge about protective put and other trading strategies.
by: Kian Elllis
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