A protective put might be the closest you can come to having your cake and eating it too, at least as far as finance is concerned. It is a strategy based on the elective nature of options contracts, in which the investor buys both a put-position options contract and a long position in the underlying asset itself. This is a way of profiting off rising prices while hedging against falling ones. Here’s how it works.
A financial advisor can help you incorporate a number of risk management strategies in your investment portfolio.
What Is a Protective Put?
A protective put is a mixed strategy that employs both options and an underlying asset. Typically this strategy uses a mix of options and stocks, although you can use any asset so long as you can find a corresponding options contract for it.
To create a protective put an investor opens two simultaneous positions:
- A long position in a given asset;
- A put option in that asset equivalent to their long position.
In layman’s terms, this means that you will buy the asset that you want to invest in. Then you will take out a put options contract for that asset. Your put contract will be for the same amount of the asset (for example the same number of shares that you bought), and its strike price will be at or near the asset’s current price.
For example, let’s say that XYZ Corp. currently sells for $50 per share. You might build a protective put out of this stock like this:
- You buy 100 shares of XYZ Corp. stock at its current price. This takes a long position in the stock, as you now profit if the price rises above $50.
- You buy one put contract for XYZ Corp., giving you 100 shares, with a strike price of $50. This contract profits if XYZ Corp.’s price falls below $50.
You can also create a protective put out of an existing asset. For example, say you currently own 100 shares of stock in XYZ Corp. which you purchased at $50 per share. Regardless of its current price, you can buy a put contract for 100 shares of XYZ Corp. with a strike price of $50, creating an after-the-fact protective put.
How Does a Protective Put Work?
The goal of a protective put is to profit off rising prices while protecting yourself against a potential fall. If the price of the asset rises, your long position makes money. Your put option expires worthless and you never exercise that option. You sell the asset and make a profit, less the cost of the options contract premiums. However, if the price of the asset falls, your put position makes money equivalent to the amount that your long position loses. For example if you take out a protective put on shares of stock, your put option will gain $1 in value for every $1 your stock loses. You will exercise your option and sell your asset, with the one offsetting the other. Your only losses will be your contract premiums.
The best way to think about this is as a way of hedging your bets or taking out an insurance policy. In exchange for paying the premium on the options contracts, your put contract ensures that you can’t lose too much money on this investment. However, there’s no such thing as a zero-risk trade. There are two very important things to remember about a protective put:
First, this strategy actively loses you money in cases of low volatility. You have to spend some money on the options premiums up front. If your asset doesn’t gain enough money to offset those premiums, you will lose money no matter what. Since you are buying an option contract at or close to the asset’s current price, these premiums will often be fairly high.
Second, you have to build this investment around the put contract’s expiration date. An options contract is not an indefinite investment. Typically they stay good only for up to one year. You must be prepared to either sell this investment or write off the premiums within that time frame.
Your put contract premiums define the upper end of risk in this position. While a protective put makes it harder to profit, when properly executed you cannot lose more money than you spend on the put contract.
Important Note – It is common to set the strike price of a protective put equal to the purchase price of the asset (in our example above, $50 per share). However, that is not necessary. You can set your strike price lower than the asset’s price. This will reduce your premiums, making the protective put less expensive, at the cost of less risk protection.
In that case your maximum risk is defined as: (initial asset price – strike price) x number of shares + contract premiums. For example, say we set our strike price for XYZ Corp. at $48 and a $1 per share premium. In that case our maximum risk would be: ($50 – $48) x 100 + $100 = $300. We can lose up to $300 on this position if it closes at or below $48 per share.
A Protective Put in Action
Let’s revisit our example from above. We want to create a protective put in XYZ Corp. which is currently trading for $50 per share. We would open the following position:
- Buy 100 shares of XYZ Corp. at $50 per share;
- Long-Put contract on XYZ Corp., Strike price $50 per share, Expiration date January 1
Our up-front costs are:
- 100 Shares of XYZ Corp. at $50 per share = $5,000
- 1 Put Contract on XYZ Corp., Premium at $1 per share, 100 Shares per contract = $100
We will spend $5,100 up front. This position expires on January 1. At this point we have four outcomes:
- Write off the premiums
We might decide to hold our stocks in XYZ Corp. for a longer-term investment, having bought the put contract just in case of any unexpected or black swan events during the year. We allow the contract to expire and write off the $100 premiums in pursuit of (hopefully) a greater long term gain.
- XYZ Corp. falls to $40 per share
- Hedged loss scenario
In this case, our stocks have lost $10 per share. The total value of our stock position is now $4,000.
However, our options contract has gained an equivalent $10 per share. The total value of our put position is now $1,000.
We close out our investment on January 1. We gain $4,000 from selling our shares of XYZ Corp. and $1,000 from exercising our option contract. This gives us: $5,100 spent up front – $5,000 gains = $100 loss.
This is the benefit of a protective put. We cannot lose more than $100 no matter how far this stock falls. Once the price of XYZ Corp. goes below $50, we gain $1 on the options contract for every $1 we lose on the shares of stock. The premium we paid for put contract defines the upper end of our exposure.
- XYZ Corp. goes up to $50.50 per share
- Risk scenario
In this case our stocks have gained $0.50 per share. The total value of our stock position is now $5,050.
Our options contract expires worthless, as the price has gone up against a put position.
We close out our investment on January 1. We gain $5,050 from selling our shares of XYZ Corp. and nothing from the put contract. This gives us: $5,100 spent up front – $5,050 gains = $50 loss.
This is the risk of a protective put. Unless XYZ Corp. goes up by at least $1.00 per share by January 1 we will lose money on this position. The tradeoff for the protection of a protective put is that your asset can gain value while you still lose money. Understanding this breakeven point is absolutely critical for any protective put investment.
- XYZ Corp. goes up to $55 per share
- Reduced gains scenario
In this case our stocks have gained $5 per share. The total value of our stock position is now $5,500.
Our options contract again expires worthless, as the price has gone up against a put position.
We close out our investment on January 1. We gain $5,500 from selling our shares of XYZ Corp. and nothing from the put contract. This gives us: $5,500 gains – $5,100 spent up front = $400 in profits.
Note that this is the mixed benefit of a protective put. As with any long position, our gains are theoretically unlimited. Technically there’s no limit to how high XYZ Corp.’s share price can go. However, at all times our profits will be reduced by the premiums we paid on the put contracts. We sacrifice a portion of profits in exchange for protection against losses.
This sacrifice will likely be considerable. While you can set any strike price for your put contract, this strategy is most useful when you buy a put contract near the current price of the asset. Since this means that your contract has a pretty good chance of expiring in the money, the premiums will be fairly high. A protective put position offers excellent protection against loss, but you should expect it to also be fairly expensive.
The Bottom Line
A protective put, also known as a married put, is a position that you take if you generally expect that your asset will gain value but have reason to be concerned nonetheless. It entails buying a put-position options contract and a long position in the underlying asset itself. It offers excellent protection against loss, although be careful not to let your potential gains get eaten up by contract premiums.
Tips on Investing
- Hedging risk is great, but it’s also important to know when to go for those big investments. SmartAsset’s matching tool can help you find a financial advisor in your area to talk you through the pros and cons of risk management and speculation. If you’re ready, get started now.
- Whether you’re comfortable using options contracts or not, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect how your money grows.
Photo credit: ©iStock.com/dszc, ©iStock.com/guvendemir, ©iStock.com/g-stockstudio