A protective put, also known as a synthetic long call, 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 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.
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.
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 trades down 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.
There 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.