What to Know About Buying Protective Puts
If you’re a bullish investor who wants to protect against the possibility that shares of your stock could drop, you might want to consider protective puts as a strategy. While options trading can be confusing when you first get started, protective puts are actually a great alternative to stop calls, allowing you to limit potential losses and even hold on to the stock longer, as you wait to see if it will go up again.
Before you decide whether protective puts are something you want to try with your own portfolio, let’s take a deeper look at what they are, why some traders choose to use them as part of their investing strategy, and some of the main pros and cons.
- A protective put is when you buy a put option on shares of stock that you own to limit the downside risk.
- Protective puts are often a better alternative to a stop order since they limit losses while giving you full control over whether you sell.
- Protective puts limit losses in a volatile or bearish market, while still allowing you to retain your shares of the stock to see if they go back up in price or to wait out dividend payments.
What Is a Protective Put?
A protective put is a strategy where an investor uses an options contract to protect themselves against losses when they own a particular stock. In other words, it’s a hedging strategy where an investor is buying a put option on stocks to protect themselves against the downside.
Understanding Stock Options
A stock option is a contract for the right to purchase or sell shares, usually 100 shares per contract, of an underlying stock at a specific price, the strike price, and by a certain date before the option expires. They are not, however, obligated to do so. They could simply choose to let the option expire without taking any further option. Investors pay a fee called a premium for the right to buy or sell the shares, which is the greatest risk that an options buyer has.
There are two types of stock options: call options and put options. A call option is the right to buy shares of stock, so investors usually will use this type of strategy if they anticipate that the price of the shares will be going up. A put option is an option to sell shares of the stock. The investor might choose to buy a put option if they think that the price of the shares is going to go down. If the price drops below the strike price, they can exercise their put option and sell.
How Protective Puts Work
Protective puts are used when an investor already owns or purchases shares of stock that they plan to hold in their portfolio. In other words, traders use protective puts when they hold a long position. Traditionally, any investor who buys shares of a stock accepts the risk that they will take a loss if the price of the stock drops below the purchase price for the shares. However, if an investor buys a put option, the protective put sets a floor price, at which point the investor knows they don’t continue to lose money, even if the price of the stock continues to fall.
The Strategy Behind Protective Puts
Image via Unsplash by Chris Liverani
B uying protective puts are useful if your outlook on the market is bullish, but you still want to protect your portfolio against the possibility of a downturn. Protective puts often are used as an alternative to a stop order. A stop order is an instruction to buy or sell shares of a stock if the price of the shares reaches a certain price level. Traders use stop orders to protect against downside losses, triggering a market sell order if the price of the shares reaches the stop price.
The problem with stop orders is that they sometimes trigger when you don’t actually want to sell. For example, if the market is highly volatile and prices are rapidly fluctuating, the price of your shares could drop to the stop price even though the price of the stock was never actually plummeting. However, by hitting that price, you would have triggered a sell order and sold when you didn’t actually want to, which means you might not be too happy when the price of your shares bounces back.
On the other hand, if you buy a protective put, you limit against the downside while still retaining control over whether or not you actually sell. That said, this level of control does come at a cost: the price for the put option. A stop order is free, while you have to pay a premium for the stock option.
Married Put vs. Protective Put
A married put and protective put are actually identical strategies. The only difference between the two happens when the stock is acquired. A protective put is when you purchase a put option to hedge against the downside for a stock that’s already in your portfolio. If you buy shares of the stock and purchase the put option at the same time, then it’s called a married put.
Why Traders Use Protective Puts
Protective puts actually allow investors to hold on to shares of a stock longer than they otherwise would have. For example, let’s say you owned shares of stock for $50 per share, and the stock market plummeted and dropped to $35 per share. If you didn’t have a protective put, you might be tempted to sell right away to prevent further losses.
If you owned a protective put with a strike price of $40 per share, you could continue holding on to the shares up until the time they were about to expire to see whether the price of the shares went back up or continued to drop. In other words, because you own a protective put, you have nothing more to lose by holding on to them as long as you make your decision by the time the options contract expires.
Investors often choose to use protective puts if they expect:
- Increased volatility: If you are anticipating a period of volatility in the market, then it can be a good idea to purchase protective puts to protect your position in a bearish market.
- Dividend payments: If you want to hold onto shares of a stock in anticipation of an upcoming dividend payment, buying a protective put could minimize the risk of losses and still ensure that you can hang on to the stock until the dividend is paid.
- Temporary weaknesses in company stock: If you’re anticipating a poor earnings report or temporary weakness in a company’s stock for another reason, buying a protective put can protect you against the downside of those dips. It also means that if the company shares quickly bounce back, you can still retain your stock.
Pros and Cons of Protective Puts
When a trader buys a protective put, they’re protecting against downside losses while still preserving the ability to earn greater profits if the price of the shares goes up, since they aren’t obligated to exercise their option. The maximum loss for this type of strategy is the cost of buying the shares of the stock and the price of the premium less the strike price for the put option. In other words, the strike price creates a barrier, at which point the investor won’t see any further losses.
The ideal scenario is if the price of the stock increases significantly, and the investor is only out the cost of the premium. In this situation, the investor would just allow the put option to expire.
In this scenario, the investor has downside protection in the event that the price of the shares drops below the strike price. They know there is a limit to how much they can lose. The protective puts also allow the investor to retain their stock, retaining their long position for however long they want for potential unlimited gains.
If an investor buys a protective put and the stock goes up, then the investor will have wasted the money they spent on the option. This ultimately reduces the profit for the trade. If the stock does go down in price, though the investor knows there is a limit to how much they can lose on the trade, the premium adds to their losses.
Protective puts are just one type of strategy you may want to consider using when trading stocks. Typically, investors who see the greatest success when trading are those who find a solid strategy and stick with it consistently. They may not win every time, but those traders generally win far more often than they lose.