Protective put: What it is, how it works and examples
What is a protective put?
A protective put is an options strategy in which you, the investor, buy a put option on a stock you already own, to protect against potential losses if the stock price declines. Puts are traded on various underlying assets, which can include stocks, currencies, commodities, indices and more. Throughout this article, we will be using stocks as our primary example.
Think of protective puts as a way to manage market risk. When used properly, they are a great tool for investors who want to participate in the stock market but also want a level of market risk mitigation in times of market volatility and in downturns.
How does a protective put work?
Put options work by allowing you to sell a specific amount of an underlying stock at a predetermined price. Put options work by allowing you to lock in a predetermined price (known as the strike price) at which you can sell a specific stock, even if the price continues to fall lower, effectively limiting your losses. You’d be able to do so until the predetermined expiry date, the date by which you have the right (but not the obligation) to exercise the put option. Keep in mind that once the expiry date passes, the option expires.
A protective put is a strategy where you combine a put option with a stock you already own.
These options can be purchased for a fee, known as a premium. A fitting name, given that puts are often compared to insurance. Like insurance, puts can help limit your potential losses. Essentially, by paying this premium, you get the right to “make a claim” by exercising the put if the stock price falls below the strike price. It makes sure that losses don’t fall outside your comfort zone.
With a protective put strategy, which involves owning the stock and the put option, there is no limit on how much your stock can increase in value. So, while they offer a floor on how far your investment can drop, there is no ceiling should the stock price soar. That’s good news for you!
Example of a protective put strategy
You purchase 100 shares of ABC stock on January 1 at $250. You like the long-term prospects of ABC but also have concerns that there could be some shorter-term volatility, so you also purchase 100 accompanying put options with a strike price of $200 and an expiry date of January 1 of the following year. If at any point in the year the price of ABC stock falls below $200, you can exercise your put options and sell the stock at $200, even if the price continues to fall. If the price drops to $190, $150 or even $0, you can still collect $200 for the 100 shares, thanks to your put options. In this scenario, the protective put strategy has limited your downside risk while still giving you the upside potential should ABC take off.
Who should consider a protective put strategy?
Protective put strategies can be useful for a variety of investors, especially those who are interested in upside market potential, but also want to focus on preserving their invested capital.
They can help you stay invested in the stock market in good and bad market conditions alike, which is an important aspect of successful long-term investing. That’s because with a protective put strategy, investors can eliminate the impossible job of timing the market, where missing the mark comes with financial consequences. This is especially important for investors who have a lower risk tolerance, because with this strategy, they will feel less inclined to sell their investments at the first sign of a market decline. Instead, by staying the course, investors can take advantage of the stock market’s long-term return potential.
Keep in mind that there are costs associated with purchasing these options (the price of premiums). However, for the added layer of defence, this can be a worthy tradeoff for many. If you’re prone to short-term trading as a knee-jerk reaction whenever markets dip, and find yourself selling low and buying high, you might want to consider a protective put strategy.
How put options can be used in your portfolio
Managing put options for an entire portfolio can be a daunting task, even for experienced investors. It’s not uncommon for portfolios to contain hundreds of stocks, and handling put options for all of them isn’t realistic for most investors. That’s why it might be a smart move for many investors to consider other strategies, such as investing in a mutual fund that incorporates put options. This approach means an experienced portfolio manager is addressing important considerations such as the appropriate strike price and expiration date for the options, as well as carefully selecting the most suitable stocks for an options overlay, taking into account the costs associated with purchasing these options.
Consider strategies such as Fidelity SmartHedge™ U.S. Equity Fund. Fidelity’s extensive research capabilities and investment expertise make it possible for investors to access a sophisticated derivatives-based strategy.