Protect Against a Drop in Price
Protect Stock Holdings from a Decline in Market Price
Protective Puts as a Hedge
This segment begins with examples of situations in which buying protective
puts might make good investment sense.
Who Should Consider Using Protective Puts?
An investor who currently holds a stock, but does not want to sell because
he believes the stock may rise in value. This investor would like to be
able to participate in the rise without risking all of his profit (if any).
An investor who is considering purchasing a stock but is concerned with
Today, investors are often concerned with the many uncertainties of the
stock market. During bull markets, investors are worried about market
corrections, and during bear markets, they are worried that their stocks
could fall further. This uncertainty can lead to a reluctance to invest, and
strong up moves might be missed. Buying puts against an existing stock
position or simultaneously purchasing stock and puts can supply the
insurance needed to overcome the uncertainty of the marketplace. People
insure their valuable assets, but most investors have not realized that many
of their stock positions also can be insured. That is exactly what a
protective put does. Typically, by paying a relatively small premium
(compared to the market value of the stock), an investor knows that no
matter how far the stock drops, it can be sold at the strike price of the
put any time up until the put expires.
Although a protective put may not be suitable for all investors, this
strategy can provide the protection needed to invest in individual stocks in
volatile markets because it ensures limited downside risk and unlimited
profit potential for the life of the option.
Buying a protective put involves the purchase of one put contract for every
100 shares of stock already owned or purchased. A put gives the owner the
right but not the obligation to sell the underlying security at a certain
price (the strike or exercise price) up to the expiration date. Puts (and
calls) are available with expirations of up to eight months on over 2500
stocks, and for over 1300 stocks as far out as three years. The options that
expire up to three years in the future are called LEAPS®, Long-term
Equity AnticiPation Securities™®.
Purchasing a put against stock is similar to purchasing insurance. The
investor will pay a premium (the cost of the put) to insure against a loss
in the stock position. No matter what happens to the price of the stock, the
put owner can sell it at the strike price at any time prior to expiration.
Let's take a look at what happens to a protective put position as the
underlying stock moves up or down. Commissions have not been taken into
consideration in these examples; however, they can have a significant effect
on your returns.
How to Use a Protective Put as Insurance
We will discuss three possible scenarios at expiration:
Buy ZYX at $50
First, let's look at buying a stock without owning a put for protection.
If stock is bought at $50 per share, as soon as the stock drops below
the purchase price, the investor begins to lose money. The entire $50
purchase price is at risk. Correspondingly, if the price increases, the
investor benefits from the entire increase without incurring the cost of
the put premium or insurance.
When only the stock is bought, there is no protection or insurance. The
investor is at risk of losing the total investment.
Buy ZYX at $50, Buy ZYX 50 Put
Let's now compare buying ZYX stock to buying ZYX with a protective put.
In this example, ZYX is still at $50 per share. A six-month put with a
strike price of 50 can be bought for 2.25 or $225 per contract
(2.25 x $100). This put can be considered insurance "without a
deductible," because the stock is purchased at $50 and an "at-the-money"
put with the same strike price, 50, is purchased. If the stock drops
below $50, the put or insurance will begin to offset any loss in ZYX
(less the cost of the put).
||Buy ZYX and 6-month 50 put
No matter how low ZYX falls, buying the six-month put with a 50 strike
price gives the investor the right to sell ZYX at $50 up until
expiration. The downside risk is only 2.25: the total cost for this
position, $52.25, less 50 (strike price). This strategy gives an
investor the advantage of having downside protection without limiting
upside potential above the total cost of the position, or $52.25. The
only disadvantage is that the investor will not begin to profit until
the stock rises above $52.25. If ZYX remains at $50 or above, the put
will expire worthless and the premium would be lost.
If just the stock had been bought, the investor would begin to profit as
soon as the stock rose above $50. However, the investor would have no
protection from the risk of the stock declining in value. Owning a put
along with stock ensures limited risk, while increasing the breakeven on
the stock by the cost of the put, but still allowing for unlimited
profit potential above the breakeven.
Buy ZYX at $50, Buy ZYX 45 Put
If an investor would like some downside protection on a stock position,
and is willing to have a deductible in exchange for a lower insurance
cost, buying an "out-of-the-money" put may meet his needs. ZYX could be
purchased at $50 along with a 6-month put with a 45 strike at a cost of
1 or $100 per contract. This put gives the owner the right but not the
obligation to sell ZYX at $45 no matter how far the stock drops in value
during the life of the contract. Buying the put with a 45 strike and
purchasing the underlying stock at $50 is similar to buying insurance
with a $5 deductible.
If ZYX declines, the put will partially offset the loss in the stock
below a price of $45. The investor has two choices: he can exercise the
put to sell the stock or he can sell the put. If the investor believes
that ZYX has finished declining he may choose to sell the put. Below 45,
the put will be worth at least the difference between the current stock
price and the strike price. The profit earned from the sale can be used
to offset some of the loss in the stock, while holding onto ZYX in
anticipation of the stock rising again. However, once the put has been
sold, the investor no longer has downside protection on the stock
The only disadvantage to this strategy is that the investor will not
profit from this transaction until ZYX rises above 51. Had just the
stock been bought, the investor would begin to profit as soon as the
stock rose above $50. But by purchasing the put, the most that can be
lost on this position by expiration is $6, and the investor still
retains all the gain in the stock above $51.
||Buy ZYX and 6-month 50 put
||Buy ZYX and 6-month 45 put
Buying the stock without put protection, with an "at-the-money" put or
with an "out-of-the-money" put have different advantages and risks. Puts
allow an investor to select the risk/reward best suited to that
This strategy does not place a cap on how high the stock can be sold.
Owning a protective put against a stock position ensures limited risk
without limiting profit potential (above the breakeven) for the life of
Protective Puts Give You Options
If ZYX had been purchased at $50 without a put and the investor was right
(ZYX rose to $65) what could he do? Without knowledge of the protective put,
he has two choices: Hold onto ZYX and hope that it continues to go up or
sell it now and take his profit. Now he has a third choice: buy a put. A put
with a strike price of 55 might cost .125 ($12.50). This 55 put gives the
investor the right to sell ZYX at $55. With this position he can continue to
hold the stock hoping it will rise further, while knowing that he can always
sell it at a profit of 4.875 (sell at 55 strike price - $50 stock purchase
cost - .125 put cost) no matter how far the stock falls. Other investors
could consider buying other puts that might cost more but also protect more
of the accumulated profit.
Keep in mind that protective puts do expire, sometimes before they provide
any insurance value. To benefit from a protective put strategy over a long
period of time, an investor can either buy LEAPS®, which are simply
long-term stock and index options, or, if they are not sure how long they
will want insurance, they could repeatedly buy short-term puts. Repeatedly
buying or "rolling" short-term puts gives the owner the flexibility of
easily adjusting the strike price as the stock moves but may result in a
higher cost than initially purchasing a LEAPS® put.
The potential volatility of the equity markets can be of great concern to
investors. The purchase of a protective put can give the investor the
comfort level needed to purchase individual securities. This strategy is
actually more conservative than the purchase of stock. As long as a put is
held against a stock position there is limited risk; you know where the
stock can be sold. The only disadvantages are that money cannot be made
until the stock moves above the combined cost of the stock and the put, and
that the put has a finite life. Once the stock rises above the total cost of
the position, however, an investor has the potential for unlimited profit.
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