What is a Protective Put & How to Trade it

A protective put is an options-based strategy designed to hedge against potential losses in a long position, particularly in stocks. Essentially, a protective put functions like purchasing insurance for an investment. When buying a protective put on a stock you already own, you gain the right, but not the obligation, to sell the asset at a predetermined strike price before the option expires. If the price of the underlying asset falls below the strike price, the holder can exercise the option to sell the asset at the higher strike price, helping to limit downside risk.

While the protective put strategy offers downside protection, it comes with a cost—the premium paid for the option(s). This strategy can be attractive to investors who want to retain the upside potential of their position while mitigating concerns about price declines. However, due to the cost of the option's premium, upside gains (if they develop) will be partially offset by this expense. On the other hand, if the market experiences a sharp downturn, the protective put can help offset losses in the underlying long position, providing a helpful layer of protection during a selloff. 

A protective put provides downside protection for an existing long position. In this strategy, the investor first holds (or establishes) a position in an underlying asset—typically a stock—anticipating it will appreciate over time. To hedge against the risk of a significant price decline, the investor then purchases a put option(s) on the asset. This put option gives the investor the right, but not the obligation, to sell the asset at a predetermined strike price before the option expires.

In exchange for this protection, the investor pays a premium, which represents the cost of the “insurance.” If the price of the underlying asset falls below the strike price, the investor can exercise the option to sell the asset at the higher strike price, thus limiting potential losses. This makes the protective put particularly useful in times of uncertainty, as it allows investors to maintain their positions while mitigating the risk of near-term declines.

It’s important to keep in mind, however, that while a protective put can help limit downside risk, it also comes at a cost—the premium paid. This premium reduces the upside potential of the combined position (stock and option), because the investor/trader has used capital to protect the position. If the underlying asset's price rises, the investor still benefits from appreciation in the long stock position, but the profit is diminished somewhat by the cost of the put option(s).

It should be further noted that the number of put contracts needed to fully protect a position depends on the number of shares held. For example, if an investor holds 200 shares, two put contracts would be required to protect the entire position, because each option contract covers 100 shares of stock. In some cases, market participants elect to protect only a portion of their position. This might be done to save on premium, depending on one’s outlook and risk profile. For example, purchase one put contract, instead of two, to cover 200 shares of long stock.

When you have an existing long position (or establish a new one), and want to protect that investment, a protective put options strategy is one possible approach. Instead of selling the asset, you buy a put option on the same underlying asset. This gives you the right, but not the obligation, to sell the asset at a predetermined strike price before the option expires. The strike price acts as a safety net, setting a floor for the price at which you can sell the asset if it declines significantly.

Because options have expiration dates, it’s crucial to choose a suitable expiration date for the protective put option(s). Generally, investors opt for longer expiration periods to allow more time for the asset to appreciate, or for market conditions to stabilize. However, that’s not always the case. Long expiration periods are generally associated with higher premiums, which may not be attractive, depending on one’s outlook and risk profile. So the duration of the put is a key consideration when building the protective put strategy. 

Once the protective put is in place, the strategy works by helping to limit your losses if the asset’s price declines. If the asset's price falls below the strike price, you can exercise the put and sell the asset at that higher price, helping to offset losses in the long stock position. On the other hand, if the asset’s price rises, the value of the put option will likely decrease, and the capital paid for the options may be forfeit. In the latter case, the loss will be represented by the premium paid to establish the option(s) position. 

In some instances, investors and traders may choose to “roll” the protective put by purchasing a new put option with a later expiration date. This can be done by simultaneously selling the original, shorter-dated put and buying the new, longer-dated put, effectively creating an options spread. Alternatively, the new protective put might be established after the original one expires. However, the rolling process allows the investor/trader to maintain continuous protection. 

Let’s consider an investor who owns 100 shares of a stock, currently trading at $50 per share, and wants to protect against the possibility of a short-term price decline while maintaining long-term upside potential. To do this, the investor buys a protective put option with a strike price of $50, paying a premium of $2 per share. This provides the right to sell the stock at $50 per share if the price falls below that level, limiting the downside risk. In this example, we’ll explore two scenarios: one where the stock price declines below the strike price and one where it remains above it.

Scenario 1: Stock Price Drops to $40

Initial Setup:

• Original Stock Position: 100 shares at $50 = $5,000

• Protective Put: Purchased for $2 per share, for 100 shares = $200 premium paid

After the Stock Drops to $40:

• Stock value: 100 shares x $40 = $4,000

• Put option value: The option now has intrinsic value since the stock is below the strike price ($50). The value of the put is the difference between the strike price and current price: $50 - $40 = $10 per share. Put value: 100 shares x $10 = $1,000

Profit and Loss:

• Stock position loss: $5,000 (initial) - $4,000 (current) = $1,000 loss

• Put position gain: $1,000 (new value) - $200 (premium paid) = $800 net gain from the put.

Net result:

• Total loss from stock position: $1,000

• Total gain from put position: $800

• Net loss = $1,000 (stock loss) - $800 (put gain) = $200 net loss.

Takeaway:

• Without the protective put, the stock position would have posted a $1,000 loss when the underlying dropped from $50/share down to $40/share. 

• However, with the protective put in place, that loss was reduced from $1,000 to only $200. 

Scenario 2: Stock Price Rises to $60

Initial Setup:

• Original Stock Position: 100 shares at $50 = $5,000

• Protective Put: Purchased for $2 per share, for 100 shares = $200 premium paid

After the Stock Rises to $60:

• Stock value: 100 shares x $60 = $6,000

• Put option value: Since the stock price is now above the strike price of $50, the protective put expires worthless. There is no intrinsic value left for the put.

Profit and Loss:

• Stock position gain: $6,000 (current value) - $5,000 (initial value) = $1,000 gain from the stock position

• Put position loss: The put option expires worthless, so you lose the premium paid. Loss on the put: $200

Net result:

• Total gain from stock position: $1,000

• Total loss from put position: $200

• Net gain = $1,000 (stock gain) - $200 (put loss) = $800 net gain

Takeaway:

• Without the protective put, the stock position would have posted a $1,000 gain when the underlying rose from $50/share to $60/share. 

• However, with the protective put in place, that gain was reduced by $200 (the premium paid), resulting in a net gain of $800. 

• While the protective put doesn’t offer any additional upside in this scenario, it does provide downside protection, which was its primary purpose.

A protective put strategy offers several key benefits for investors looking to manage downside risk while maintaining potential upside. One of the primary advantages is the ability to limit losses in a declining market. By purchasing a put option, an investor can establish a “floor” for the price at which they can sell their asset, effectively protecting against significant declines. This provides peace of mind during periods of market uncertainty, allowing the investor to weather short-term volatility while still holding onto their long-term investment.

Another key benefit is the ability to retain upside potential. Unlike other risk management strategies, such as selling the underlying stock position outright, the protective put allows investors to continue benefiting from potential price increases in the core position. While the premium paid for the put reduces overall profitability, the strategy provides a balanced approach—offering downside protection while still enabling participation in the asset’s growth. For investors who are concerned about market fluctuations but don't want to miss out on potential gains, the protective put can be an attractive option—especially when there is concern about a significant drop in the underlying stock.

While a protective put strategy offers valuable downside protection, it does come with several disadvantages. The primary drawback is the cost of the put option(s). To implement this strategy, investors must pay a premium for the put, which can accumulate over time, particularly if the stock doesn’t decline as anticipated. This premium represents an upfront cost, and if the asset price remains flat or rises, it becomes a sunk cost that reduces overall profitability.

Another limitation is the expiration date of the put option. If the stock price moves unfavorably after the option expires, the investor may find themselves without protection. Therefore, managing the timing of the put is crucial, as its protective benefit only lasts until expiration. If market conditions change after the option expires, the investor may need to purchase additional protective puts, further increasing the overall cost of that protection. Over time, the combined cost of the put premium may outweigh the benefits of protection, especially if the underlying asset doesn’t decline in price. 

• A protective put is an options strategy that allows an investor to hedge against potential losses in a long position by buying a put option on the underlying asset. It provides the right to sell the asset at a predetermined strike price, offering downside protection.

• Protective puts offer downside protection by allowing investors to sell an asset at a predetermined strike price, helping to limit potential losses.

• The cost of the protective put (the premium) is a key factor; it is paid upfront and reduces overall profitability if the stock price remains flat or rises.

• If the stock price declines below the strike price, the protective put can help offset the loss by allowing the investor to sell the asset at a higher price than the current market value.

• However, if the stock price rises, the protective put expires worthless, and the investor loses the premium paid.

• Protective puts are particularly useful when investors want to retain upside potential, while hedging against price declines.

• Importantly, the put option expires after a set period, meaning the protection only lasts until the expiration date. To maintain the protection, the investor/trader can “roll” the protective put using an options spread. Or establish a new put position after the other one expires.

• If the protective put expires before the stock moves lower in price, the investor will be left unprotected. 

• While protective puts limit losses, they also reduce profits since the premium paid for the put(s) reduces overall returns, especially when the stock price moves sideways or higher. 

• Over time, the cost of purchasing protective puts can accumulate, potentially outweighing the benefits.