What is Protective Put and how does this strategy work?

In hedging, we have a number of strategies to limit the risk of losing profit and to minimize losses. In this article, we have discussed what is a protective put strategy and how they work in the option market.

Protective put is a hedging strategy which uses put option contracts to reduce the potential risk of owning a stock. Protective put is used by those traders and investors who are bullish on a particular stock but in the short term they have a bearish view.

How protective put option strategy works?

Protective put is also referred to as a married put.

If traders and investors are expecting the market price of a stock to decline to a certain level, then they can buy a put option contract to profit from the short term decline.

Investors who own shares of a listed company can buy put option contracts of the same stock in case they expect a short term decline in market price. They buy put option contracts with a strike price below the current market price of the stock to limit their losses.

Which means they are long on a stock and simultaneously they buy OTM puts of the same stock to cover their losses. Protective put is used when traders have a bullish view on the stock but want downside protection.

Put option gives them the right to sell, but not the obligation, at a fixed price on a predetermined date. In case of an American option, the contract can expire on or before the date of expiry. In the case of the European option, the contract can only be expired on the date of expiry. In India, we follow European style. In the US they follow both European and American styles.

Traders use a protective put strategy when they intend to remain invested in a stock for the foreseeable future, but want to protect their profits in the event of selling pressure ahead of news and earnings.

Opposite of the protective put strategy is known as Naked put.

A naked put is a strategy where a put option is bought by itself without any offsetting position. Naked put is also referred to as an “uncovered put” or “short put”.

Also read: What is the difference between call option and put option

Example of Protective put strategy

Suppose, Mr Kumar owns 1000 shares of a listed company ABC limited at a price of Rs 100.

Now Mr Kumar has a short term bearish view on ABC limited. As per his analysis, he is expecting market price of ABC limited to come down by 10%.

To take advantage of this short term price movement, if he buys put option contract of ABC limited stocks at a strike price of Rs 90 (or any amount which is lower than the current market price of Rs 100), then it will be referred to as protective put as you own stock of ABC limited along with put option on ABC limited stock with a strike price of Rs 90.

For buying the put option, you have to pay a premium to the seller. By paying a premium, you basically limit your maximum loss on the ABC limited stock to the difference between the current market price and the strike price.

Let us assume Mr Kumar has paid Rs 1 as premium for buying the put option contract.

Now, if the price of ABC limited shares comes down, you can exercise your put option contract to sell at a price of Rs 90. In this case, your loss per share is Rs 11 (100-90-1).

suppose, the price of ABC limited comes down to Rs 80 on the date of expiry. Your loss in this case without a put option would have been Rs 20 (i.e. 100-80). By exercising your put option rights, you sold your shares at Rs 90, therefore, your loss now is Rs 11, i.e. market price while taking put option minus strike price plus premium paid for put option (Rs 100-90+1)

Now, by using a protective put strategy, you have restricted your losses from Rs 20 per share to Rs 11 per share.

Buyer of the put option has also the right to not exercise the put option, meaning they can choose to let the put option contract expire by not exercising it. In this case, the loss will be only the premium paid to buy the put option.

Protective put strategy is used to limit your potential losses. Traders use this type of hedging strategy when they own a stock but are worried about a significant downturn in its price. Which means, they want to remain invested but do not want to afford a catastrophic loss.

This type of protective put strategy is effective for short term traders. Value investors do not use this type of strategies as they believe in buy-and-hold. If you don’t know how and when to use a protective put strategy, then in the long run it can drag down your investment return.