A protective put strategy, also known as a synthetic long call or married put, is an options strategy that consists of buying or owning the stock, and then buying one put at strike price A. The investor who enters this strategy wants the stock to trade higher, but also wants protection in case the stock price falls below strike price A, giving the investor the right to sell the stock.
This strategy is usually applied when the investor is nervous about the market and wants downside protection while allowing themselves to make profits on the upside. The protective put acts as a price floor, which limits the amount an investor can lose if a stock continues to trade down. Once the stock moves under the strike price of the protective put, the investor protected from enduring anymore losses.
How to Use the Protective Put
If an investor is already long stock, that investor is risking taking losses if the stock trades down. However, by purchasing a protective put option, an investor is guaranteeing his/her ability to sell the stock at a specific price if the stock continues on a path lower, thus capping their losses.
Because the investor has a contract in place to sell a stock, if they so choose, at a specified price, they are creating a price floor that protects their asset.
The protective put acts like insurance on the asset, and just like all types of insurance, there is a premium paid for this protection. The premium is based on where the investor wants to add his/her price floor, as well as volatility, which represents the likelihood of the price of the stock falling even further. There is also a time limit on how long the insurance last, the more time the investor wants on his insurance, the more the protective put purchase price will be.
Strike Prices for Protection
When executing a protective put, an investor has several options, including what level strike price to execute and the expiration date. Typically investors select an out of the money put option. This is when the strike price is below the current stock price. This does not provide complete protection, as is the price gap between the current stock price and the level where the protective put adds insurance. However, the premium paid for this protective put is less.
Investors that are more concerned about downward stock price movement may also buy-in at the money put. This more aggressive protective put provides 100% protection from potential losses, but the premium paid for this level of insurance is higher.
Long-term protective puts also result in higher premiums.
Profit/Loss
The maximum profit is unlimited as owning the stock allows the investor to continue to make money as the stock trades higher.
The maximum loss is calculated by taking the difference between the stock price and the long put, then adding the cost of the put. For example, if the stock was trading $100, and the investor acquired a 95-strike put for $1.50, then the maximum loss would be $6.50.
Breakeven
A protective put’s breakeven point is stock price plus the put price. For example, $100 stock price plus $1.50 put price means the stock would have to trade up $1.50 to cover the cost of the put, so $101.50 would be the breakeven.
Example
If XYZ is trading $100 and is expected to trade higher over the next three months, a trader could buy the stock and a 95-strike price put for the following price:
- Buying 100 shares of XYZ stock at $100
- Buy 1 XYZ 95-strike price put for $1.50
If the stock trades up to $105 at expiration, the investor will make $5.00 on the stock, but because they spent $1.50 on the put, they will have a net gain of $3.50.
If the stock price declines to $91 at expiration, then the trader will exercise the 95-strike price put, selling the stock at $95. This would mean they took a $5.00 loss on the stock, but because they bought the protective put for $1.50, they would have a total loss of $6.50.
Conclusion
The only reason to buy a protective put is to limit losses on the downside when acquiring the stock or by adding the protective put to an already existing stock position.
By being long a put an investor benefits from a rise in implied volatility as the value of that put increases along with the rise in implied volatility. A decrease in implied volatility would result in the put losing value and hurt the investor.
This is an excellent strategy for a beginner who wants to buy insurance for their long stock position. Before entering any options strategy, is important to understand all aspects of the trade and how each aspect can affect the profit or loss of the position.
