Protective Put Strategy: A Detailed Guide

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Synopsis:

A protective put strategy can help traders deal with stock market volatility. It can help them limit their losses, as traders can buy a put option, which can provide them with a right to sell a share at a certain price.

The protective put strategy helps traders limit their losses, specifically when the stock market is volatile. Under this strategy, investors buy ‘put options’, which provide them the right to sell a stock at a predetermined price. In this blog, we will discuss how this strategy works and important factors to keep in mind while using it.

Highlights

  • Protective put option strategy: How it works?
  • Factors to keep in mind while using a protective put strategy
  • Conclusion

Protective put option strategy: How it works?

Let us take an example to understand the put option strategy better. Suppose an investor owns a stock called ‘X’. He bought X for Rs. 100 a share. The price of X increases to Rs. 200. What can the investor do?

Either he can sell the share and earn Rs. 100 profit or he can wait to see if the price increases further. But, there is an element of risk here. In the event the price of X declines, he will not be able to make Rs. 100 profit.

Therefore, he buys a put option, which gives him the right to sell X for Rs. 150. This allows him to protect his profit to a certain extent. Suppose the price of X falls to Rs. 120. In that case, if he had not bought the put option, his profit would have been limited to Rs. 20. However, since he has bought a put option, which gives him the right to sell the stock at Rs. 150, his profit is Rs. 50.

That said, he needs to deduct the premium he must have paid to acquire the put option from Rs. 50. Suppose that premium was Rs. 5, his net profit is Rs. 45 even if the price of X falls to Rs. 120.

Now, imagine that the price of X increases to Rs. 250. In that case, the investor can book a profit of Rs. 150, but the put option contract will be worthless. That is fine because the purpose of such a contract is to reduce the extent of losses. The only thing is that the profit of Rs. 150 will have to be reduced to the extent of the premium (Rs. 5), which means the net profit will be Rs. 145.

Additional Read: What is Put Option & How to Trade Them

Factors to keep in mind while employing a protective put strategy

  • Strike price: A put contract allows a trader to sell a stock at a pre-determined price, also called the 'strike price'. It is the most important factor to consider while buying a put option. Typically, investors should choose a strike price, which is only a bit less than the current market price of a stock. Such an option will limit their losses should the stock crash significantly.
  • Expiry date of a put option: While buying a put option, an investor must ensure that the expiry date is in line with his investment horizon. Suppose an investor’s investment horizon is six months, but a put option gives him the right to sell the stock in nine months. This will not make sense because the two horizons are quite different.
  • Premium: The premium or the price of a put option is also a crucial factor. If it is extremely high, it may not make sense to buy that option. Therefore, investors must always consider the premium while buying a put option.
  • Market conditions: Investors should always assess market conditions while buying a put option. If such conditions are volatile, a put option can help them limit their losses. However, if the market conditions are not volatile and are likely to remain stable, then it may not make sense to buy a put option.

Conclusion

The protective put strategy can certainly help investors, especially when the market is volatile. However, an investor needs to know the pulse of the market while employing a strategy like this.

A put strategy, like all options trading strategies, can be inherently risky. It also requires investors to be very knowledgeable. After all, a put option is a derivative contract. Its value depends upon the underlying stock. To invest in such contracts, an investor must understand both the underlying stock and the derivative contract.

Additional Read: Introduction To Put Writing

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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