The Ultimate Guide To The Protective Put Strategy

When someone concurrently holds a long position in a stock and a long position in a put option on that stock, the put is called a protective put. The put protects against losses in the value of the underlying asset. An investor will buy a protective put when his outlook on the stock is bullish, but he wants to protect the value of the stocks in in the event of a downturn.

You can think of protective put as a savvy investor’s alternative to entering a stop order. Stop orders are a great way to limit an investor’s loss, as they allow the investor to exit out of a position when the stock hits a particular price. However, stock orders often get triggered prematurely with fluctuations in the stock price.

On the other hand, a protective put gives you some control as the long put gives you the right, but not the obligation, to exercise your option to sell the stock at a predefined price. The catch is you have to pay a premium upfront to buy the put.

Let’s look at an example of when someone would buy a protective put. Suppose an investor is long 100 shares of Uber (UBER) at $36.50 as of September 11, 2020. The investor’s research suggests there may be a negative shock to the stock price in the next three to five weeks.

He doesn’t want to exit out of his stock position because he wants to preserve the upside. But at the same time, he wants protection from downside risk. He looks at the options chain and notes the following put prices and put greeks.

Exhibit 1

Exhibit 2

Exhibit 3

Exhibit 4

Exhibit 5

A put represents the right to sell at a strike/exercise price, so the higher the strike price, the more expensive the put will be.

Also, longer maturity puts will be more expensive than their equivalent shorter maturity puts, as longer maturity puts provide more time for the investor to exit the position (Exhibit 1). Which put should the investor buy depends on the investor’s stock outlook, as well as the greeks, such as delta, theta, gamma, and vega.

Generally speaking, traders should buy long-dated options, as the option value decays slowly and picks up the pace as it reaches expiration.

Maximum Loss

The investor paid to enter the protective put, so he is down the premium immediately. In the Uber example, let’s say the investor bought the $36 exercise October 23 put at $2.14. The moment he places the order, he must pay $2.14 per 100 shares to buy the downside protection.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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