What Is a Protective Put in Options Trading?

If you are an investor looking to protect yourself from potential losses in trading, the protective put is a strategy to consider. It is a risk-management tool that uses puts to limit downside risk for a cost, similar in some ways to the concept of insurance. This article will explain the mechanics of the protective put, its benefits, considerations and when it is appropriate to use. 

What Is a Protective Put?

A protective put is an options trading strategy that aims to protect against potential loss in an investor's asset, like a stock position. Put options give you the right to sell the underlying asset at a predetermined price, known as the strike price, by or at the option's expiration date. In a protective put, you buy an asset and buy the put option on the asset. 

This strategy is useful for investors with a long position in an asset who want to limit their exposure to downside risk. But the cost of the put option must be paid upfront and may not be regained.

How Does a Protective Put Work?

Protective puts are risk-management tools used to help protect long positions in a stock or asset against unexpected events that could trigger a drop in the stock price. 

If the stock price falls below the strike price minus the premium, you can exercise the option and sell stock at the strike price potentially for a profit. But if the stock price increases, you can choose not to exercise the put option. In that case, it will expire worthless. Because you own the stock, you would still benefit from the stock's appreciation, although you will lose the put option premium.

What Does a Protective Put Mean for Individual Traders?

For individual traders, a protective put can be a valuable risk-management tool that tends to do well if the underlying asset price declines. Traders have to pay an upfront premium to own the option, but that is the maximum that can be lost.  

How to Set Up A Protective Put

You can set up a protective put in a few straightforward steps. Here’s an example using a stock as the underlying asset:

1. Identify the Stock You Want to Buy and Protect

The first step is to identify the stock you want to hedge with a protective put. This could be a stock that you already own or one that you plan to buy.

2. Choose the Option Expiration Date

Consider a timeframe that you expect your trading view to play out. The farther out the expiration date, the more expensive the option will be.

3. Determine the Strike Price

This is the price at which you can sell the stock if the option is exercised. To lower the cost of the premium you would choose a strike price below the stock's current market price. Typically the strike price would be the same price you paid for your stock for a hedge against a price drop below the cost basis 

4. Buy the Put Option

Once you have determined the expiration date and strike price, you can buy the put option through your broker. Make sure you understand the terms of the option contract, including the premium — the price of the option — and any fees associated with the trade. Also pay attention to whether you can exercise the option any time up to the expiration date or only upon expiration.

Examples of Protective Put

Let's say you buy 100 shares of technology company XYZ, which currently trades at $150 per share. You fear the stock is about to decline in value, but you don't want to sell the shares because they could still appreciate in the future. To hedge against the risk of a price decline, you buy a protective put contract with a strike price of $150 and a premium of $6. 

The following scenarios might play out at expiration

Scenario 1: Share Price Above $150

You can continue to hold the stock and benefit from gains, which can be calculated as: Ending share price - (initial share price of $150 + put premium of $6). The put option would expire unexercised.

Scenario 2: Share Price Between $150 and $156

With a small share price increase, you risk losing the put premium or breaking even at best. The put option will not be exercised.

Scenario 3: Share Price Below $150

You can exercise your put option by selling the shares at the strike price of $150 per share. However, you will only make money on the put option if the stock price is below the breakeven point of $144, which is the strike price minus the premium of $6. In this case, you will make a profit of $6 per share on the put option, which will offset some of your losses on your stock position.

Potential Advantages of a Protective Put

You can use a protective put for the following advantages, including:

• Limited downside risk: You limit your potential losses against price decline past the put strike price for the cost of the premium.
• Flexibility: You can choose the strike price and expiration date of the put option, allowing you to tailor the strategy to your specific risk tolerance and investment goals.
• Potential for upside gains: If the stock appreciates, you can hold onto the asset and let the put option expire while still gaining from an increase in stock price.

Things to Consider with a Protective Put

While a protective put can be an effective risk-management tool, there are also factors to  consider before implementing this strategy:

• Cost: Purchasing a put option can be expensive, and the cost can eat into potential profits. You must carefully consider whether the cost of the option is worth the potential downside protection.
• Time decay: Like all options, put options have an expiration date. As the option contract approaches its expiration date, the time value of the option decreases, making it less valuable.    
• The strike price: If the strike price is set too high, you may end up paying too much for the option. If the strike price is set too low, the option may not provide adequate downside protection.

Put Options Provide a Hedge for a Cost

A protective put serves as a form of insurance, providing a risk management strategy to investors with long positions in assets while limiting downside risk — for a cost. Using this option strategy requires careful consideration of factors such as the strike price and expiration date. The strategy can be a risk-management tool for traders.

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