In this article, we will discuss the protective put option, how it works, and whether it is a good idea for investors. We will divide the article into the following sections:
Definition of Protective Put Option
A protective put option is a strategy that reduces the potential risks of owning a stock. Investors who own shares in a company can buy put options, which give them the right to sell those shares at a specified price. Protective put options involve purchasing puts with strike prices lower than the current market value of the stock to minimize losses.
Definition and Examples of Protective Put Option
A protective put option is a type of put option strategy that helps investors minimize their maximum losses from owning a stock. This strategy is often used by investors who expect a long-term increase in the stock price but anticipate a short-term decline.
When you own a stock, you can profit if the stock price rises. You can lose money if the stock price declines. Your maximum loss is equal to the stock’s value multiplied by the number of shares you own.
For example, if you own 100 shares of XYZ, and each share is priced at $25, then you have a $2500 investment. If XYZ becomes worthless, you could lose $2500.
Note: Put options give the option holder the right, but not the obligation, to sell shares to the option writer at a specified price known as the strike price.
Continuing with the above example, you would use a protective put option if you purchased a put option on XYZ with a strike price of $20 in addition to the shares you own. With this put option, you can sell your shares to the option writer at $20 per share, regardless of their market value.
You have to pay a fee when purchasing the option, so this also factors into your profit or loss calculations. These fees are usually higher the closer the strike price is to the current market value of the stock and the longer the time between the current date and the option’s expiration. They would also be higher for securities with a high market capitalization.
How Does Protective Put Option Work?
You can think of protective puts as insurance. You pay a fee to buy a put option at a strike price lower than the current value of the stock you own. In return, you cap your maximum loss on the stock at the difference between the stock’s current value and the strike price listed in the option.
Note: The protective put option sets a minimum price at which you can sell the shares, which limits potential losses.
Let’s illustrate this with the XYZ example. You have 100 shares of XYZ that you purchased at $25 per share. You also have a put option on XYZ with a strike price of $20, and let’s assume you paid $2 as a premium for the option. Therefore, your breakeven point is $20 – $2 = $18.
Now, if the price of XYZ shares starts to decline, you can minimize your loss by exercising the put option and selling your XYZ shares at $20 per share.
Assuming the price of XYZ falls to $10 per share. Your loss for each share of XYZ that you purchased is $10 – $25 = -$15. Your profit from exercising the put option and selling the XYZ shares at $20 would be $20 – $10 = $10.
Your total net for each share is:
Loss on stock price + Profit from exercising put – Option fee = -15 + 10 – 2 = -7
Using the above figures, your maximum loss would be ($7) * 100 = $700, which is a significantly smaller loss than the maximum loss ($1500) without the protective put.
In
At the same time, you have no obligation to exercise the sale, which means you can choose to let it expire, losing only the fee you paid. This means that if the price of the stock you hold increases, you won’t limit your potential profit.
Advantages and Disadvantages of Protective Put Options
Advantages
Reduced potential losses: With protective put options, there is a minimum price at which you can sell your shares, limiting the amount of loss you can incur from holding a stock.
Does not affect potential profit: Because you are not obligated to exercise the sale, it will not affect your potential profit if the stock price rises significantly.
Disadvantages
You have to pay a fee for the option: Each time you buy an option, you have to pay a fee, which means you are paying for protection.
Regularly buying protective put options can impact your returns: If you buy protective put options regularly, you may spend substantial amounts on fees. In the long run, this could reduce your overall returns, especially if you are paying high fees.
What Does This Mean for Individual Investors?
Protective put options are a choice for investors who want to hold a stock but are concerned about a significant drop in its price. You can use them if you want to invest safely but cannot afford catastrophic losses. Alternatively, you could rebalance your portfolio to reduce investment risks, such as increasing your bond holdings relative to your stock holdings.
For investors looking to invest long-term and hold stocks, protective put options may not be particularly useful as they are more effective at reducing losses in the short term. If you are investing for something like retirement, it is likely that protective put options will not be a beneficial strategy for you.
Key Points
- Protective put options reduce potential losses from holding stocks.
- Protective put options do not affect the maximum profit from holding stocks.
- Like other types of insurance, you have to pay a fee to purchase protective put options.
- In the long term, buying protective put options can affect your investment returns.
Source: https://www.thebalancemoney.com/what-is-a-protective-put-option-5205232
Leave a Reply