How to Use a Protective Put
Three common motivations for using a protective put may be to protect:
- unrealized profits from previously purchased shares
- a new stock purchase
- previously purchased shares that have declined in value from further downside loss
In the first case, an investor purchased shares in the past that have increased in value over their initial cost and so has unrealized profits. He considers the stock a good investment, has a bullish outlook over the long term and wants to continue owning the shares. However, he might be concerned about either bearish sentiment in the broad market or the possibility of a sudden market correction. A put purchase can at least partially protect those profits.
In the second case an investor might be bullish on a given stock and is considering a new stock purchase. However, he is also concerned about the possibility of a temporary market decline. Buying a put concurrently with the stock purchase offers this investor the downside protection he wants from the onset of his stock position.
Finally, an investor owns stock that has declined in value and so has unrealized losses. Because he still has a positive outlook on those shares over the long term and does not want to sell them, he wants to protect them from further downside risk. This investor is willing to commit a relatively small amount of cash to his losing stock position and so purchases a protective put.
In any of these cases, the degree of protection provided by the long put depends on both the strike price chosen and an option expiration month that reflects the investor's timeframe for potential downside risk
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
An investor purchases 100 shares of ZYX stock at $52. If a protective put isn't purchased, as soon as the stock drops below the purchase price the investor will begin to lose money and the entire $52 purchase price is at risk. On the other hand, if the stock price rises the investor benefits from the entire increase without incurring the insurance cost of the put premium.
Let's take a look at this investor's choices for purchasing insurance on his stock holdings and consider three scenarios:
- the stock has increased in value and protection for unrealized profits is purchased
- a put is bought at the same time the stock is purchased
- the stock has decreased in value and protection from further loss is desired