WHAT IS PROTECTIVE PUT STRATEGIES?

 

   A protective put strategy is a commonly used risk management technique in options trading. It involves buying a put option for a stock that an investor already owns to protect against potential losses from a decline in the stock's price. This strategy is akin to purchasing insurance on the stock: while it limits downside risk, it still allows for potential upside gains. Let’s explore the protective put strategy in detail, breaking it down into its components, mechanisms, advantages, and considerations.

 

Components of the protective put strategy

 

Underlying stock ownership:  The investor owns shares of a stock or exchange-traded fund (ETF). The key point here is that the investor anticipates the stock’s price to increase or remain stable in the future, but they are worried about short-term downside risks due to volatility, earnings reports, or broader market concerns.

 

Put option purchase:  A put option gives the owner the right, but not the obligation, to sell a specified quantity (typically 100 shares per contract) of the underlying stock at a predetermined price (the strike price) before the option’s expiration date. In a protective put strategy, the investor buys a put option to hedge the risk of the stock's price falling.

 

Strike price:  This is the price at which the put option can be exercised. The investor chooses the strike price based on how much risk they are willing to take. For example, if the stock is trading at Rs.100, the investor might buy a put option with a strike price of Rs.95, meaning that if the stock price falls below Rs.95, they can sell the stock at that price.

 

Expiration date:  The investor selects an expiration date for the put option. The expiration date determines the period for which the protection is valid. It’s essential for the investor to match the expiration date with the time frame during which they expect potential downside risk.

 

Mechanics of a protective put

 

The protective put strategy works by offsetting potential losses in the stock with gains in the put option if the stock’s price declines. Here’s how the strategy plays out in different market scenarios:

 

If the stock price increases:

 

The stock appreciates in value, and the put option expires worthless.

The investor enjoys the full upside potential of the stock, less the premium paid for the put option (the cost of "insurance").

For example, if the stock price increases from Rs.100 to Rs.110, the put option with a strike price of Rs.95 expires worthless. The investor gains Rs.10 per share on the stock but loses the premium paid for the put option.

 

If the stock price decreases:

 

The put option provides protection by allowing the investor to sell the stock at the predetermined strike price.

Losses in the stock are capped at the strike price of the put option, minus the premium paid for the option.

For example, if the stock price falls to Rs.80 and the investor bought a put option with a strike price of Rs.95, the investor can sell the stock for Rs.95 instead of Rs.80, effectively limiting the loss.

 

Breakeven point:

 

The breakeven point for the protective put strategy is the stock price at which the total value of the stock (including the premium paid for the put option) equals the initial cost of the stock and the option.

For example, if the stock price is Rs.100 and the put option premium is Rs.2, the breakeven price would be Rs.102 (the stock price plus the option premium). If the stock rises above Rs.102, the investor makes a net profit, while if it falls below Rs.102, the investor incurs a loss.

 

Key benefits of the protective put strategy

 

Downside protection:  The primary advantage of a protective put is that it limits losses in the event of a sharp decline in the stock price. The investor has the right to sell the stock at the strike price, ensuring that losses are capped.

 

Upside potential:  Unlike strategies such as covered calls, which limit the potential for upside gains, a protective put allows the investor to benefit fully if the stock’s price appreciates. This makes it an attractive choice for investors who are bullish on a stock but want protection against adverse market movements.

 

Flexible risk management:  Investors can tailor the protective put strategy to their risk tolerance by selecting different strike prices and expiration dates. For example, choosing a higher strike price (closer to the current stock price) provides more protection but costs more in premiums, while a lower strike price reduces costs but offers less protection.

 

Psychological comfort:  Having a protective put in place can provide peace of mind, especially during periods of market volatility. Investors may feel more comfortable holding onto their stock positions without fearing large losses.

 

Drawbacks and considerations

 

Cost of the put option:  The main drawback of the protective put strategy is the cost of purchasing the put option. The premium paid for the option reduces the overall return on investment, particularly if the stock price increases and the option expires worthless. In some cases, investors may need to buy multiple put options over time if the stock's price doesn’t increase quickly enough, adding to the total cost.

 

Time decay (Theta):  Options lose value as they approach their expiration date due to time decay. The longer the investor holds the protective put, the more the option’s value erodes, especially if the stock price remains stable or increases. This can make it less attractive to hold long-term protection using options.

 

Selection of strike price and expiration date:  Choosing the right strike price and expiration date is crucial for the strategy's success. If the strike price is set too low, the protection may not be sufficient, and if the expiration date is too short, the protection might expire before the stock moves.

 

Opportunity cost:  The protective put ties up capital in an option that may expire worthless, which represents an opportunity cost. The investor could have used the funds for other investments, such as buying additional shares of the stock or other assets.

 

Practical example of a protective put strategy

 

Let’s say an investor owns 100 shares of Apple Inc. (AAPL), which is trading at Rs.150 per share. The investor is bullish on the stock’s long-term prospects but is concerned about potential short-term market volatility. To protect against a possible decline in AAPL’s stock price, the investor buys one put option contract with a strike price of Rs.140, expiring in three months. The put option premium is Rs.5 per share, or Rs.500 for the contract.

 

Scenario 1:  The stock price rises: If AAPL’s stock price increases to Rs.160, the put option expires worthless, and the investor loses the Rs.500 premium. However, the investor gains Rs.10 per share on the stock, resulting in a total gain of Rs.1,000 (100 shares * Rs.10), minus the Rs.500 premium, for a net profit of Rs.500.

 

Scenario 2:  The stock price falls: If AAPL’s stock price declines to Rs.130, the investor exercises the put option and sells the stock for Rs.140 per share. The investor loses Rs.10 per share on the stock but gains Rs.10 per share on the put option, effectively capping the loss at the Rs.500 premium.

 

Conclusion

 

   The protective put strategy is a powerful tool for investors looking to protect their stock positions from downside risk while maintaining exposure to potential upside gains. By purchasing a put option, investors can hedge against adverse price movements, providing insurance-like protection in volatile markets. However, the strategy comes with a cost in the form of option premiums, which can eat into profits if the stock price increases or remains stable. Careful selection of strike prices, expiration dates, and timing is essential to maximize the strategy’s effectiveness and minimize costs. Overall, the protective put is a versatile strategy suitable for conservative investors looking for a balanced approach to risk and reward.