Options Strategy: Protective Put

In this guide, we will cover an options strategy called a protective put. A protective put is a hedging, or risk management, strategy. We will look at how to set up a protective put, what the profit and loss potential of a protective put are and what to consider when using a protective put.

ProsCons

Minimizes potential losses (hedging strategy)

Protection ends when option expires

No limit on profit potential

Small portion of profits sacrificed due to option premium

What is a Protective Put?

A protective put, sometimes also called a married put, is an options strategy when an investor purchases a put option on a security he owns (most commonly stock). An investor can also purchase the stock, or other security, and put option simultaneously to set up this strategy. A protective put is sometimes also referred to as a synthetic long call, because its profit and loss potential is the same as buying a basic call option. As the name implies, a protective put is used to hedge, or protect against losses on the value of the stock.

How To Set Up a Protective Put

Purchase or own stock

Buy put option on stock

Let’s say you owned stock that you purchased for $45 per share. You decide to also buy a put option on this stock with an exercise/strike price of $40 and a premium of $5. If the stock price goes up to $55 by the expiration date, you will not exercise the put option, because you don’t want to sell stock worth $55 for only $40. In this case, you will let the option expire. If the stock price declined to $30 by the expiration date, you will want to exercise the option, because you can now sell stock worth only $30 for $40.

Typically, investors setting up a protective put will buy either an at the money or out of the money put option on the stock. This means if the stock price is $40, an at the money put would have an exercise price of $40 or very close to $40 and an out of the money put would have an exercise price below $40. A put option with an exercise price above $40 would be considered in the money.

Profit and Loss of a Protective Put

The profit of a protective put is calculated using the exercise price, the option premium, original purchase price of the stock and the ending stock price. The way you calculate profit depends on whether the ending stock price is above or below the exercise price of the put option:

  • If the ending stock price is less than or equal to the exercise price:
    • Profit = Exercise Price – Original Stock Purchase Price – Option Premium
    If the ending stock price is greater than the exercise price:
    • Profit = Ending Stock Price – Original Stock Purchase Price – Option Premium

It’s easier to understand this if we consider an example. Let’s say you purchased IBM stock for $35 per share and you also buy a put option on this stock with an exercise price of $30 and a premium of $2.

IBM stock drops to $25 per share, and you decide to exercise the option because you can sell the stock for $30, even though it’s only worth $25 on the market. Since you originally purchased the stock for $35 and are now selling it for $30, you have lost $5 on the stock (this is a better scenario than if you didn’t have the put option, because you would have lost $10 on the stock as it declined from $35 to $25). You also paid $2 to acquire the option, so your total loss would be $7. Since the ending stock price is less than the exercise price, we can use the following formula:

  • Profit = Exercise Price – Original Stock Purchase Price – Option Premium
  • Profit = $30 - $35 - $2 = -$5 - $2 = -$7

If IBM stock dropped to $15 per share, you would still only lose $7. This is because the exercise price of the put option sets a limit on how much you can lose on the stock. In this case, you can still sell the stock for $30 by exercising the option, losing $5 since you bought the stock for $35. You paid $2 to acquire the option, meaning you will lose $7 total.

What if the stock price rises? If the stock price of IBM rose to $40 per share, you wouldn’t want to exercise the option and sell the stock for only $30. Because you bought the stock for $35, you have gained $5 by the rise in value. However, you also paid $2 to acquire the option contract, so your total profit would be $3. Since the ending stock price is higher than the exercise price of the put option, profit can be calculated as:

  • Profit = Ending Stock Price – Original Stock Purchase Price – Option Premium
  • Profit = $40 - $35 - $2 = $5 - $2 = $3

As the stock price increases, so does the profit in this situation. If IBM stock rose to $65 per share, you will have earned $30 because you purchased the stock at $35. You paid $2 for the option, so your total profit would be $28. As we can see in the graph below, the profit potential for this options strategy is virtually unlimited, whereas the potential loss is capped.

Profit for Protective Put with $30 Exercise Price, $2 Premium and $35 Original Stock Purchase Price

In our example, the maximum loss you can incur with this strategy is $7. In more general terms, the maximum loss in this situation is limited by the difference in the exercise price and purchase price of the stock plus the premium you paid to acquire the option. If the exercise price and the purchase price were the same, meaning you purchased an at the money put option, then the maximum loss is just the premium. The maximum loss can be calculated as:

  • Maximum Loss = Original Stock Purchase Price – Exercise Price + Option Premium

In theory, the profit potential on a protective put is virtually unlimited as stock prices do not have an upper limit. Your profit would be slightly less than if you had never purchased the put option, because you paid a premium to acquire the option. For example, if the price of your IBM stock jumped to $100 per share, you wouldn’t want to exercise your $30 put. Since you bought the stock for $35, you have realized a $65 gain on the stock value. Because you paid $2 for the option, the total profit would be $63. If the stock price rose even higher, your profit would subsequently increase.

Why Use a Protective Put?

The reason investors use a protective put is as a form of hedging or risk management. You can even think of a protective put as a form of “portfolio insurance” as you can limit your losses if the stock price falls precipitously. You are giving yourself a reliable exit strategy if the stock price falls below your threshold, which would be the exercise price you choose. The other upside to a protective put is that the limited risk does not materially limit the profit potential. You will always pay the premium to acquire the put, but if the stock increases in value, you will still be participating in those gains because you can keep the stock by not exercising the option. This means that investors who set up a protective put may feel that the stock price will increase, or in other words they are bullish on the stock, but they want to limit their losses in case they are wrong.

Risks of a Protective Put

The protective put is a risk management or hedging strategy, so the risks are limited as we described above. You can still lose money using a protective put, but large losses are mitigated in this strategy. For the protection offered by this strategy, you do sacrifice a small portion of the profits if the value of the stock increases, because of the premium paid to acquire the put option. The other main risk is time, as the protection offered by the strategy will end once the option expires.

What to Consider When Setting Up a Protective Put

When an investor sets up a protective put, she should typically buy an at the money or out of the money put option. It doesn’t make as much sense to purchase an in the money put option for this strategy, because you would be sacrificing some of the profits if the stock went up in value. Let’s say you purchase some stock at $25 per share. You see three different put options you can purchase on this stock: an at the money (ATM) put option with an exercise price of $25 and a premium of $4, an out of the money (OTM) put option with an exercise price of $20 and a premium of $2 and an in the money (ITM) put option with an exercise price of $30 and a premium of $8.

If the stock price went up to $30, you would likely not exercise any of the options. Your profit on the $20 put would be $3, this is because you earned $5 since the stock price went up to $30 from $25, but you paid $2 for the premium. Your profit on the $25 put would be $1, as the stock price went up $5, but you paid $4 for the premium. On the $30 put, you would actually incur a loss. You would still gain $5 from the value of the stock increasing, but you paid $8 for the option, so you would lose $3 total.

Stock Price

OTM Put Profit/LossATM Put Profit/LossITM Put Profit/Loss

$18

-$7-$4-$3

$20

-$7-$4-$3

$22

-$5-$4-$3

$24

-$3-$4-$3

$25

-$2-$4-$3

$26

-$1-$3-$3

$27

$0-$2-$3

$28

$1-$1-$3

$29

$2$0-$3

$30

$3$1-$3

$31

$4$2-$2

$32

$5$3-$1

$33

$6$4$0

As we can see in the table above, the ITM put produces a loss more times than both the OTM and ATM puts. It does offer better risk protection, because the investor can always sell the stock he bought for a gain (if he bought the stock for $25, then he can always sell it for $30 with the ITM put). Since an investor may set up a protective put when they feel bullish about the stock, it may not be worthwhile to sacrifice profits on the value of the stock for more risk protection.

A Note on Brokerage Fees

In our examples above, we have not included brokerage fees in calculations for profit or loss. Brokerages charge a variety of fees for buying and exercising options that can eat into an investors’ returns. If you are considering options, you should understand the fees and charges on the purchase, sale and exercise of options. To calculate profit with brokerage fees, use the formulas above and subtract any fees that would be applied if you bought, sold or exercised the option.

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