Suppose that you own 100 shares of a stock that you think is undervalued. The company is doing everything right, management is growing the company, and it continues to beat earnings expectations.
This sounds like the perfect stock – one you’d like to keep in your portfolio. But while you’re sure about the company, you’re not sure about the short-run. What should you do? Consider a protective put, of course!
How Protective Puts Work
Protective puts are used to put in a “floor” for how much an investor can lose on any given position. A protective put strategy locks in gains and limits losses, but it also reduces slightly the total return for the investor should a stock advance higher.
Let’s use a current example to show exactly how a protective put strategy works:
Below you’ll see the options chain for Microsoft (MSFT) and the cost to purchase a put at any given strike price with an expiration in January 2014. These prices are available at the time of writing in August 2012.
Microsoft currently trades for $29.75. If you owned 100 shares of Microsoft stock worth $2975, you could purchase a protective put to protect your whole investment. You might purchase an in-the-money put with a $30 strike price. The cost for 100 options to match your 100 share position in MSFT would be $445. (The ask price of $4.45 x 100 options equals $445.
How This Trade Could Play Out
If Microsoft continues to rally to $40 per share, you would make $10.25 per share that you own on your stock position. However, you would lose the $4.45 per option that you paid for the protective put. Work it out: $10.25 gain on shares plus a $4.45 per share loss equals a net gain of $5.80. You stand to gain $5.80 per share when without the protective puts you would have gained $10.25 per share.
If Microsoft were to fall to $20, however, you would lose $9.75 per share that you owned. However, your puts at the $30 strike price would be worth $10 each. Work it out: $9.75 loss plus a $5.55 gain on your put options equals a net loss of $4.20 per share. You stand to lose only $4.20 per share despite the fact that the stock fell by $9.75.
Why Use Protective Puts
The beauty of stock options is that you can hold a position much longer than you might be able to hold it without protective puts. For example, Microsoft might have a one-day dip to $15 per share. If you hold the stock, you might want to sell at $15 per share. The gains on protective puts buffer the loss and allow you to keep holding. In effect, you stand to lose nothing more than what you paid for the options when you use a protective put strategy. However, you also risk losing potential upside should the stock continue to move higher.
Most traders use protective puts when they anticipate:
- Greater volatility – It would have been a great idea to purchase protective puts on a portfolio in September and October of 2011. The market took a brief dip due to the European Debt Crisis, and those who purchased protective puts were able to capitalize by protecting their positions in a down market.
- Future dividend payments – You might want to hold onto a stock for an upcoming dividend payment. A protective put allows you to minimize losses in the period while still ensuring that you own the stock until the dividend is announced. There are plenty of strategies that call for the use of a protective put before an ex-dividend date, or the “cut-off” date for dividend payments to stock holders. If you want a dividend payment, but you’re afraid of short-term weakness in a stock, a protective put is a great way to reduce your risk of capital loss until the ex-dividend date.
- Temporary weakness – No business goes up in value in a straight line. If you’re concerned about an earnings miss or temporary weakness in a company’s stock, a protective put can help you minimize the chance of loss and lock in profits. Plus, you’ll still get to hold your shares in the event that the company shakes off weakness and the stock continues a long established rally.
Protective Puts are Insurance
The short explanation is this: protective puts are a cheap form of insurance which minimize the downside risk of owning an individual stock. For this insurance, an investor also gives up some of his or her upside should a stock move higher. It’s a trade-off to be made, and it should be done with careful consideration of how the company is performing, and how the market will respond to the company’s performance.