Successful investors are just as concerned with managing risk as they are with maximizing returns. After all, the primary goal for investors should be maximizing risk-adjusted returns rather than total returns. Stock options provide a great way to help manage risk with their tremendous flexibility and controllable costs. In particular, protective puts are widely used to help limit downside risk.
In this article, we’ll take a look at the protective put options strategy, dynamics of the trade, and some important risks to consider.
Be sure to also read Options 101: American vs. European vs. Exotic.
What Is a Protective Put?
Protective puts are simply long put options backed by shares of the underlying stock. While setting a price floor in the event that the underlying stock falls, the options strategy permits investors to retain unlimited upside potential. The only catch is the premium paid for the long put option, which adds to the cost basis of the aggregate stock and option position in a given security.
For example, suppose that an investor purchases 100 shares of ACME at 100.00 per share. The investor decides to limit his or her downside by simultaneously purchasing a long put option with an 80.00 strike price and a 5.00 premium. If the stock falls to 70.00, the investors can still sell the position for 80.00, although the cost basis for the entire trade is now 105.00 per share.
If you’re sitting on a losing trade, be sure to also read Don’t Fret, Salvage Your Losing Position with Options.
If the stock rises significantly, the investor can sell the put option to recoup some of the premium paid, although the option trade will still result in a loss. The option will eventually expire, however, requiring the investor to either give up the downside protection or purchase a new long put option to regain protection. When near-term options are sold to purchase long-term options, it’s known as rolling out the trade.
Suppose that an investor owns 100 shares of AAPL at $100.00 in January. After hearing about some potential production issues, he or she decides to enter into a protective put by purchasing a put option that expires in April with a 100.00 strike and a premium of $400.00. The option insures the long stock position against a possible crash, setting a floor at $100.00 per share.
Now, let’s take a look at three possible scenarios:
- Apple Falls from $100 to $50. At $50.00, the long stock position will suffer a loss of ($100.00 – $50.00) x 100 = $5,000, but the option position will have an intrinsic value of $5,000 and could be sold for that amount. Including the $400 option premium, the net loss would be $5,000 – $5,000 + $400 = $400.
- Apple Rises from $100 to $150. At $150.00, the long stock position will gain ($150.00- $100.00) x 100 = $5,000. Excluding the $400 premium paid for the put option, the investor’s net profit would be $5,000 – $400 = $4,600.
In essence, the protective put strategy capped the investor’s losses at $400, while leaving unlimited room for upside potential. The doubling of Apple’s stock to $200 per share would still be offset by only a $400 premium paid for the put option. On the downside, Apple’s stock could sink to $5.00 per share and the investor would still only lose $400 in the premium paid for the put option.
See also 4 Ways to Exit a Losing Trade.
Risks and Considerations
A protective puts is one of the most conservative options strategies available, since investors know exactly how much they could lose at the onset. As a result, there are very few risks associated with using the protective put strategy, although there are a few important considerations to take into account:
- Commissions – The calculations in the example above didn’t account for the cost of commissions. While these figures are usually minimal, they can add up over time and should be carefully considered.
- Breakeven – Protective puts raise the bar for a stock position’s returns in order to achieve profitability. Investors using longer term protective puts may experience higher breakeven points for profitability.
The Bottom Line
Protective puts are a great way to protect an existing stock position against downside without sacrificing much in the way of upside. While the strategy is rather straightforward, investors should carefully consider the breakeven dynamics and ensure that the upside they are sacrificing is acceptable given the risk of decline. Properly used, the strategy provides a great addition to any investor’s toolbox.