Protective Put

Definition

 

The owner of the Equity/ stock buys the PUT Options (generally out of money) by paying the premium.

The Owner has the right (but no obligation) to sell the underlying stock at the Strike price before the expiration date even if the stock price at expiration is much less than the Strike price.

When to run the strategy

The owner of the Stock is expecting the Stock to go up but also wants to protect his investments from the downward movement

The strategy is like buying the investment for the stocks in your portfolio

Benefits of strategy

You own the underlying stock and can benefit if the stock price goes up

If the stock price goes below significantly, you don’t have to worry since you can get out of your position as per your contract.

Your loss is limited to the premium you paid to buy the PUT.

Transactions

You buy the Equity at Price (E) (say $100).

You Sell the call (generally Out of the Money) at the Strike Price (S) (say $110).

You receive the premium (P) (say $7).

Potential profit Max Profit

There is no max limit to the profit. 

Theoretically you can have unlimited Profit

Example:

Stock Purchase Price:        $100

Stock price at expiration(say):  $400

Premium:                          $7

So Profit = $400 - $100 - $7 = $293

Max Loss

Potential Loss is

(Stock Purchase Price – Strike Price) – Premium Paid

Example, 

          Stock Purchase Price          $100

          Strike Price (say):               $  90

          Premium Paid:                    $7

So Potential Loss= ($100 - $90) - $7 = $17

Note: Even if the company goes Bankrupt or the stock price drops significantly (say 95%), you have the right to sell the stock at strike price

Breakeven point

This occurs when the loss in Premium is compensated by the increase in Stock Price. It occurs when the stock price at expiration is (Stock Purchase Price + Premium).

Example:

Stock Purchase Price - $100

Premium Paid - $7

So Stock price at Breakeven point should be (100 + 7) = $107

At Expiration

If the Stock price is below Strike price:

The PUT Option is executed i.e., Stock is removed from your portfolio and the amount equal to Strike price is credited in your account.

If the Stock price is above Strike price:

The PUT Option expires worthless.

 The Stock remains in your account.

Who should trade this?

Since this strategy is to protect the investment, it can be traded by people at all level.

Beginners               - Yes

Intermediates          - Yes

Experts                   - Yes

Masters                   - Yes

           

Time decay

Ø Time Decay will work against.

Ø The time value of option reduces on the daily basis.

Ø Even if the Stock price remains constant, the value of PUT Option will keep decreasing.

Ø The time value reduces to 0 on the day of Expiration.

Points to consider

Exit strategy: You don’t have to worry even when the stock falls significantly. You may like to book your profit when the stock rises.

Brokerage Cost: Always consider brokerage cost when making a trade.