Protective Put

The protective put, or put hedge, is a hedging strategy where the holder of a security buys a put to guard against a drop in the stock price of that security. 

Protective Put Construction
Long 100 Shares
Buy 1 ATM Put

A protective put strategy is usually employed when the options trader is still bullish on a stock he already owns but wary of uncertainties in the near term. It is used as a means to protect unrealized gains on shares from a previous purchase.

Unlimited Profit Potential

There is no limit to the maximum profit attainable using this strategy. The protective put is also known as a synthetic long call as its risk/reward profile is the same that of a long call's.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Purchase Price of Underlying + Premium Paid
  • Profit = Price of Underlying - Purchase Price of Underlying - Premium Paid
Protective Put Payoff Diagram
Graph showing the expected profit or loss for the protective put option strategy in relation to the market price of the underlying security on option expiration date.

Limited Risk

Maximum loss for this strategy is limited and is equal to the premium paid for buying the put option.

The formula for calculating maximum loss is given below:

  • Max Loss = Premium Paid + Purchase Price of Underlying - Put Strike + Commissions Paid
  • Max Loss Occurs When Price of Underlying <= Strike Price of Long Put

Breakeven Point(s)

The underlier price at which break-even is achieved for the protective put position can be calculated using the following formula.

  • Breakeven Point = Purchase Price of Underlying + Premium Paid

Example

An options trader owns 100 shares of XYZ stock trading at $50 in June. He implements a protective put strategy by purchasing a SEP 50 put option priced at $200 to insure his long stock position against a possible crash.

Max Loss Capped at $200

Maximum loss occurs when the stock price is $50 or lower at expiration. Even if the stock price nosedived to $30 on expiration, his max loss is capped at $200. Let's see how this works out.

At $30, his long stock position will suffer a loss of $2000. However, his SEP 50 put will have an intrinsic value of $2000 and can be sold for that amount. Including the initial $200 paid to buy the put option, his net loss will be $2000 - $2000 + $200 = $200.

Unlimited Profit Potential

There is no limit to the profits attainable should the stock price goes up. Suppose the stock price rallies to $70, his long stock position will gain $2000. Excluding the $200 paid for the protective put, his net profit is $1800.

Note: While we have covered the use of this strategy with reference to stock options, the protective put is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the protective put in that they are also bullish strategies that have unlimited profit potential and limited risk.

Married Put
Long Call
Call Backspread

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