Protective Put

A protective put is a risk-management strategy using options contracts that investors employ to guard against the loss of unrealized gains in a stock or other asset. In this strategy, a downside put option effectively acts like an insurance policy — it costs money (the option's premium), which reduces the investor's potential gains from owning the security but also reduces the risk of losing money if the security declines in value. The protective put sets a known floor price below which the investor will not continue to lose any more money even as the underlying asset drops.

Protective puts involve being long shares of stock and then purchasing out-of-the-money put options for that stock with a strike price that is near the underlying stock's current price. A protective put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty.

A protective put keeps downside losses limited, while preserving unlimited potential gains to the upside as the strategy involves being long on the underlying stock. If the stock keeps rising, the long stock position benefits and the bought put option isn't needed, and will expire worthless. All that will be lost is the premium paid to buy the put option. Protective puts can cover some portion of an investor's long position, all the way up to the full amount owned. When the ratio of protective put coverage is equal to the amount of long stock, the strategy is known as a married put.

The maximum loss of a protective put strategy is limited to the purchase price of the underlying stock less the strike price of the put option and the premium paid. The strike price of the put option acts as a barrier where losses in the underlying stock stop. The ideal situation in a protective put is for the stock price to increase, as the investor would benefit from the long stock position. In this case, the put option will expire worthless, but the stock will have increased in value.

If an investor purchased 100 shares of stock XYZ at $10 per share, and the price increased to $20, they have unrealized gains of $10 per share. If they don't want to sell the stock yet (perhaps because they think it will appreciate further) but they want to make sure they don't lose the $10 in unrealized gains, they can purchase a put option for that same stock (called the "underlying stock") that will protect them for as long as the option contract is in force. If the stock continues to increase in price, say, going up to $30, the investor can benefit from the increase. If the stock declines from $20 to $15 or even to $1, the investor is able to limit the loss because of the protective put.

Assume the investor purchased a put option on stock XYZ with a strike price of $15 for 75 cents. This allows the investor to sell the stock at $15, even if the stock drops all the way back to $10 or below. The option did cost $75 though ($0.75 x 100 shares), so the profit the investor is guaranteed to lock in is $425 (($15 - $10 paid - $0.75 premium) x 100). If the investor didn't buy the put option, and the stock drops back to $10, they have made $0. On the other hand, if the stock rises to $30 and they did buy the option, they have unrealized gains of $2000 ($30 - $10 paid x 100 shares) but this will be reduced by the $75 paid for the option.