Published August 29, 2011
Purchasing a protective put gives you the right to sell stock you already own at strike price A. Protective puts are handy when your outlook is bullish but you want to protect the value of stocks in your portfolio in the event of a downturn. They can also help you cut back on your antacid intake in times of market uncertainty.
Protective puts are often used as an alternative to stop orders. The problem with stop orders is they sometimes work when you don’t want them to work, and when you really need them they don’t work at all. For example, if a stock’s price is fluctuating but not really tanking, a stop order might get you out prematurely. If that happens, you probably won’t be too happy if the stock bounces back. Or, if a major news event happens overnight and the stock gaps down significantly on the open, you might not get out at your stop price. Instead, you’ll get out at the next available market price, which could be much lower.
If you buy a protective put, you have complete control over when you exercise your option, and the price you’re going to receive for your stock is predetermined. However, these benefits do come at a cost. Whereas a stop order is free, you’ll have to pay to buy a put. So it would be nice if the stock goes up at least enough to cover the premium paid for the put.
If you buy stock and a protective put at the same time, this is commonly referred to as a “married put.” For added enjoyment, feel free to play a wedding march and throw rice while making this trade.
THE SET UP
• You own the stock
• Buy a put, strike price A
• Generally, the stock price will be above strike A
WHO SHOULD RUN IT
• Rookies and higher
WHEN TO RUN IT
You’re bullish but nervous.
BREAK-EVEN AT EXPIRATION
From the point the protective put is established, the break-even point is the current stock price plus the premium paid for the put.
THE SWEET SPOT
You want the stock to go to infinity and the puts to expire worthless.
MAXIMUM POTENTIAL PROFIT
Potential profit is theoretically unlimited, because you’ll still own the stock and you have not capped the upside.
MAXIMUM POTENTIAL LOSS
Risk is limited to the “deductible” (current stock price minus the strike price) plus the premium paid for the put.
AS TIME GOES BY
For this strategy, time decay is the enemy. It will negatively affect the value of the option you bought.
After the strategy is established, you want implied volatility to increase. That will increase the price of the option you bought.
Options involve risk and are not suitable for all investors. Click here to review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult your tax adviser.
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