How A Protective Put Strategy Can Make You Money, And Help You Sleep

The last month or so the stock market has had a run-up of about 10% in terms of the S&P 500; the path wasn’t straight up, but still the rise has been quite impressive. If you are mostly long in your stock portfolio you are feeling some relief compared to the low point just before July 4th, 2010. This might be a good time to explain how a protective put strategy works, as something to consider if you are afraid that stocks may be headed down, at least temporarily, from here.

On this site you have had stock options explained to you in terms of using leverage to aggressively profit from a rise or fall in underlying stock, as well as having call and put options explained as ways to hedge existing positions, with safety as the goal.

You can use puts to protect gains that you may have in your portfolio, or more specifically profit from possible downside moves in stocks or ETF that you might own but do not wish to sell at this time. Reading the financial commentary right now, you’re hearing an awful lot about the possibility of a double dip recession, which would naturally be detrimental to your long stock positions. Buying, or going long, put options is a way to purchase some insurance for your portfolio, and though this ‘protective put’ strategy carries with it some risk, it can be put to good use just like buying insurance, because even if the events you fear do not occur, buying protective puts enable you to sleep better knowing that you have covered yourself, just in case. And, if the underlying stock should fall, the gains you see in the value of your puts will at least partially offset the paper losses you experience in your stock position.

The mechanics using this protective insurance are really quite simple: let’s use the example of Google, trading at the moment at exactly $500 per share. Let’s say that you are not optimistic on the prospects for the stock between now and the end of 2010, but you have reasons for not wanting wanting to sell your shares now, perhaps due to your long-term optimism about the company or tax reasons, etc. You could buy one protective put contract for every 100 shares of Google stock that you own (by the way, we are simply talking about puts here; the word “protective” is simply a description of how we are employing them in this case).

The Google December 2010 450 puts are trading right now at just about $1500 per contract. To review, this contract allows us to sell 100 shares of Google at $450 per share on Friday of the third week of December of 2010. So how does this contract protect our Google stock position?

Let’s say that our fears are born out and that Google is trading at $400 a share by the expiration date. Without our put contract (or multiple contracts; we probably want to purchase one contract for every 100 shares of Google stock that we are long), we will experience a substantial reduction in the value of our shares by that date. In numerical terms, a $50,000 position (100 shares times $500 per share) will become a $40,000 position.

Now, if we had purchased one protective put for $1500 in this scenario we would have a choice at expiration: our contract would be worth $5000 (100 shares times $50, which is the difference between the strike price and the price at which the stock is currently trading), and we could simply sell it for a $3500 gain to offset the $10,000 loss we took in the value of our Google position, and keep the stock for the long-term, assuming we are still optimistic about the prospect of future price gains.

Alternatively, we could exercise our put since it gives us the right to sell our Google shares at the $450 strike price. Perhaps our view of the company stock might have changed by the expiration date, and we are no longer optimistic and would prefer to exit the stock position. The put gives us the right to sell the stock at a price that is $50 higher than the current stock price. Instead of losing $10,000 on the position relative to when we entered it, we lose only $5000. The $1500 premium that we paid must also be figured calculations as, like an insurance policy, we do not get our premium amount returned to us. In this case the $1500 was very well spent though, as it saved us $3500 on what turned out to be a unfortunate trade.

Let’s say that our fears of a price drop in Google shares between now and December turn out to be unwarranted and the stock goes up or doesn’t move much during that time. Remember that as long as the stock is above the $450 strike price at expiration the put option will expire worthless and we will lose our entire $1500 premium amount. The good news is that the value of our Google position, while it may be lower than it was when we enter our position, is not performing too badly in this case and may well have risen to a healthy gain on paper, which hopefully outweighs the $1500 insurance policy that our protective put position represented.

Our maximum loss on this position should the stock go down between now and expiration, is $6500 ( the $1500 premium you pay for the put plus the $50 ie $5000 difference between the strike price and the stock price when you open your put position), which sounds like a lot until you realize that we are completely insured no matter how far the stock drops. If our put expires worthless the breakeven point for our stock position is now 15 points higher because of the cost of the $1500 protective put.

Remember that buying a put whose strike price is closer to the current stock price will cost you more money but will protect you from drops in the price of the stock below that higher strike price, thereby providing more protection. Also, you will want to examine puts with closer expiration dates as a way to save money on the initial premium that you pay, with the caveat that you obviously won’t be protected from a stock price drop for as long.

In an effort to get stock options explained adequately to you you will encounter many different strategies for options investing, and it should be clear by now that there are many ways to use options to increase your safety or protect gains that you already have by hedging with options. A protective put strategy is a very good example of conservative options trading, but do ensure that you thoroughly understand this kind of trade before you commit any real money to it.