Finance

Protective Put

Protective Put

What are Protective puts?

A protective put is a risk-management strategy using contract options employed by investors to guard against a loss in a stock or other asset. It’s a hedging technique that investors have used to purchase a put option for a fee, called a premium. A protective put’s main purpose is to limit potential losses that may result from an unexpected fall in the underlying asset’s price.

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Working of Puts:

Protective puts are widely used when an investor is long or is purchasing equity shares or other assets they plan to retain in their portfolio. A protective put strategy is typically employed by bullish investors who want to hedge their long positions in the asset. Adopting such a strategy does not put an absolute limit on the expected profits of the investor. The strategy’s profits are measured by the underlying asset’s growth potential. However, an investor loses some of their profits the form of premiums. On the other hand, the protective put strategy does create a limit for potential maximum loss, as any losses in the long stock position below the put option’s strike price would be offset by the optional gain.

For a better understanding of puts we can take an example:

You own 100 shares in ABC Corp, priced at $100 for each share. You assume in the future the price of your shares will grow. But you want to hedge against the risk of an unexpected decline in prices. Therefore, you decide to buy one protective put contract with a strike price of $ 100 (one put contract contains 100 shares). The premium of the protective put is $5.

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Case1: Share price above $105.

If the share price is above the price of the strike; i.e. $100, we’ll achieve an unrealized benefit. The profit is calculable as,

Current Share Price – $105 (it includes initial share price plus put premium). Hence, in this case, we will not exercise the protective put.

Case2: Share price between $100-$105

The share price in this case will stay the same or will increase slightly. Even the best case though, you’ll either lose money or touch the breakeven point The put will not be exercised, as in the previous case.

Case 3: Share price below $100.

In this scenario, the protective put option is exercised to minimize the losses. You’ll be selling your 100 shares at $100 once the put is exercised. But your loss will be limited to the protective put premium charged.

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Strike Prices and Premiums:

A contract for a protective put option can be obtained at any time. At the same time, some buyers will buy these and when they purchase the stock. Others could wait until a later date to purchase the contract. Whenever they purchase the option, the relationship between the underlying asset price and the strike price which position the contract into one of three categories — known as moneyness. These categories include:

  1. At-the-money (ATM) where strike and market are equal
  2. Out-of-the-money (OTM) where the strike is below the market
  3. In-the-money (ITM) where the strike is above the market

Investors looking to hedge losses on a holding focus primarily on offerings of the ATM and OTM options.

If the asset price and the strike price are the same, the contract shall be deemed to be At-The-Money (ATM). An at-the-money put option provides 100 percent protection for an investor until the option runs out. Many times, a protective put will be at-the-money if the underlying asset is purchased at the same time.

An investor can also purchase an option to put Out-Of-The-Money (OTM). Out-of-the-money occurs when the price of the strike is less than the stock or asset price. An OTM put option does not provide 100 percent downside protection, but rather limits the losses to the difference between the stock price purchased and the strike price. Investors are using out-of-the-money options to lower the premium cost as they are willing to take some amount of a loss. Also, the further the strike is below market value, the less the premium becomes.

In-the-money (ITM) is a term referring to an option that has intrinsic value. Therefore, ITM means that an option has value in a strike price that is attractive relative to the prevailing market price of the underlying asset.

For example- An investor may have agreed that they are unable to take losses above a stock fall of 5 percent. An investor could buy a put option with a 5 percent lower strike price than the stock price thereby creating a worst-case scenario of a 5 percent loss if the stock fell. Options are available for various strike rates and expiry dates, allowing investors the option to configure the protection — and the premium cost.

Potential Scenarios with Protective Puts:

A protective put keeps downside losses reduced while leaving future upside-down profits untapped. If the stock keeps rising, however, the long stock position benefits and the purchased put option won’t be required and will expire worthlessly. All that is lost is the premium charged to purchase the put option. The investor would purchase another protective put in this case when the initial put expired, again protecting their assets.

Protective puts can cover a portion of the long position of an investor or all of his holdings. If the protective put coverage ratio is equal to the long stock amount, the strategy is known as a “Married put.”

Married puts are widely used when buyers choose to purchase a stock and buy the put right away to secure the position. However, as long as an owner holds the stock, they can purchase the protective put option at any moment.

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A protective put strategy’s potential liability is limited to the expense of purchasing the underlying stock — along with any commissions — less the put option’s strike price plus the premium, and any fees charged to purchase the option.

The put option’s strike price serves as a buffer at which losses end at the underlying stock. In a defensive place, the optimal condition is for the stock price to rise dramatically since the investor will gain from the long stock position. The put option would expire worthlessly in this situation, the investor will have paid the premium but the valuation of the stock will have risen.

PROS

CONS.

  • Protective puts provide protection against declines in the price of an asset for the cost of the premium.
  • If an investor buys a put and the stock price increases, the premium rate lowers the trading profits.
  • Protective puts make it possible for investors to stay long on a stock that offers potential gains.
  • If the stock declines in price and a put has been purchased, the premium adds to the losses on the trade.

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Real-life example:

Let’s say an investor acquired 100 General Electric Company (GE) shares for $10 per share. The stock price jumped to $20, offering the investor $10 a share in unrealized gains — unrealized since it has not yet been sold.

The investor would not want to sell their GE investments, so the stock may be more valued. They don’t want to risk the $10 in unrealized gains, either. For as long as the option contract is in place, the investor can buy a put option on the stock to secure a portion of the profits.

The investor buys a put option for 75 cents with a strike price of $15 and generates a worst-case scenario of selling the stock at $15 a share. The put option expires within three months. If the price falls down to or below $10, then the holder will benefit from $15 and lower on a dollar-for-dollar basis on the put option. In brief, the investor will be hedged somewhere near $15, before the option expires.

Author: Shlok Pokhriyal

About the Author:- Shlok Pokhriyal is a second-year student who has had a very keen interest and a passion for finance. Currently pursuing financial risk management as a career.

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