Protective Puts

Learn how to use protective puts risk management strategy to hedge your existing portfolio against a sudden decrease in the stock

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Protective Puts

Learn how to set up and profit from Protective Puts

Protective put strategies can help protect you from a market that looks like trouble ahead. If you think your investments could see a temporary downturn, but don’t want to sell them, you could consider a protective put.

Breaking Down a Protective Put

A protective put strategy is analogous to the nature of insurance. The main goal of a protective put is to limit potential losses that may result from an unexpected price drop of the underlying asset.

Adopting such a strategy does not put an absolute limit on potential profits of the investor. Profits from the strategy are determined by the growth potential of the underlying asset. However, a portion of the profits is reduced by the premium paid for the put.

On the other hand, the protective put strategy does create a limit for potential maximum loss, as any losses in the long stock position below the strike price of the put option will be compensated by profits in the option. A protective put strategy is typically employed by bullish investors who want to hedge their long positions in the asset.

Example of Protective Put

You own 100 shares in ABC Corp, with each share valued at $100. You believe that the price of your shares will increase in the future. However, you want to hedge against the risk of an unexpected price decline. Therefore, you decide to purchase one protective put contract (one put contract contains 100 shares) with a strike price of $100. The premium of the protective put is $5.

Protective Put

The payoff from the protective put depends on the future price of the company’s shares. The following scenarios are possible:

Scenario 1: Share price above $105.

If the share price goes beyond $105, you will experience an unrealized gain. The profit can be calculated as Current Share Price – $105 (it includes initial share price plus put premium). The put will not be exercised.

Scenario 2: Share price between $100 and $105.

In this scenario, the share price will remain the same or slightly rise. However, you will still lose money or hit the breakeven point in the best case. The small loss is caused by the premium you paid for the put contract. Similar to the previous scenario, the put will not be exercised.

Scenario 3: Share price below $100.

In this case, you will exercise the protective put option to limit the losses. After the put is exercised, you will sell your 100 shares at $100. Thus, your loss will be limited to the premium paid for the protective put.

Breaking Down a Protective Put

Example of Protective Put

Protective Put

The payoff from the protective put depends on the future price of the company’s shares. The following scenarios are possible:

Scenario 1: Share price above $105.

Scenario 2: Share price between $100 and $105.

Scenario 3: Share price below $100.

What is an options spread?

An options spread is an options strategy involving the purchase AND sale of an option at different strike prices OR different expiration dates.

All options spread are set up as the same type. They are either all call options or all put options and on the same underlying asset

They differ in only the expiration date or the strike price.

They are set up with the same number of buy options as sell options. If you buy 5 call options, you will also sell 5 call options.

What are the 3 main types of options spreads?

A bullish long call diagonal spread is set up by

vertical spreads
horizontal spreads
diagonal spreads

What are Vertical Spreads

Vertical spreads are options that differ only in terms of strike price. They will have the same expiration and are of the same type ( all calls or all puts )

Option Basics

Motivations

This is primarily a stock acquisition strategy for a price-sensitive investor. Unlike a naked put writer whose only goal is to collect premium income, a cash-secured put writer actually wants to acquire the underlying stock via assignment. The strike price, less the premium received, represents a desirable purchase price.

However, the put assignment is not guaranteed. Should the stock price remain above the strike during the life of the option, the investor will miss out on the stock purchase. The consolation would be pocketing the premium received for the put.
If the investor is intent on acquiring the stock and is less concerned about price, there are other strategy choices worth considering.

Blurb –

Option Basics

Variations

A cash-secured put is a variation on the naked put strategy. The main difference is that the cash-secured put writer has set aside the funds for buying the stock in the event it is assigned and views assignment as a positive outcome.

In contrast, the naked put writer hopes that the put will keep losing value so the position won’t be assigned and can be closed out early at a profit. This investor would have to liquidate other assets quickly, or borrow cash, to be able to honor an assignment notice.

Blurb –

Option Basics

How Does a Call Option Change with Volatility and Time

A call option will benefit from :

A rise in stock prices
A rise in volatility
An early rise in stock price ( time kills the stock value )

Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.

Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.

Negative Theta – The passage of time will have a positive impact on this strategy, all other things being equal. As expiration approaches, the option tends to move toward its intrinsic value, which for out-of-money puts is zero. If the original forecast and goals still apply, the investor keeps the premium and is free to either buy the stock outright or write a new put.
The extrinsic value of options decays as time passes, which is detrimental to a call buyer

Positive Vega – An increase in volatility will increase the value of a call option ( indicated by positive vega ). Conversely, a decrease in volatility will decrease the value of a call option ( indicated by a negative vega ———
Whereas an increase in implied volatility would be considered an unqualified negative for a naked put writer, the effect could be described as neutral to slightly negative for the cash-secured put writer, all other things being equal.
If it now appears likelier that the put will be assigned, greater volatility is a neutral or perhaps even encouraging development.
However, greater implied volatility is clearly a negative in the sense that it can raise the put’s market value and thereby the cost of closing out the position. Remember, implied volatility is a measure of anticipated movement in either direction, up or down. Say, the investor is now convinced the stock will rally instead, and decides to purchase the stock outright before it goes any higher. Unless the investor is prepared to buy even more stock if assigned, the short put must be closed out, and its cost is now higher.

Buying a Call

Management and Adjustments

Maximum Profit Potential:
The maximum gain from the put option itself is limited. However, the optimal outcome is not readily apparent in the expiration profit/loss payoff diagram, because it does not address developments after expiration.
The best scenario would be for the stock to dip slightly below the strike price at the put option’s expiration, trigger assignment and then rally immediately afterwards to record heights. The put assignment would have allowed our investor to buy the stock at the strike price just in time to participate in the following rally.
From a strictly short-term perspective, the maximum possible gain occurs if the stock stays above the strike, causing the put option to expire worthless. The investor would keep the T-Bill cash originally set aside in case of assignment and simply pocket the premium from the sale of the option. While that is a benign outcome, it obviously doesn’t reflect the fact that the investor would rather be participating in the stock’s upward movement.
Maximum Loss Potential: The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor would be obligated to buy stock at the strike price. The loss would be reduced by the premium received for selling the put option.
Notice, however, that the maximum loss is lower than would have occurred, had the investor simply purchased the stock outright rather than via selling a put option.
Expiration Breakeven Price:
Since the object of this strategy is to acquire stock, the investor would break even if it is possible to sell the stock at the same effective price they paid for it.
Breakeven = strike price – premium
Estimated Probability of Profit: Less Than 50%
Assignment Risk?
Slight. Since the goal of this strategy is to acquire stock, assignment is not a problem. However, early exercise would require the investor to convert the interest-bearing asset to cash in order to pay for the stock.
Also, if assignment happened during a particularly severe downturn and the put writer has second thoughts about owning the stock at the strike price, the delay between assignment and notification means that the stock could fall further before the investor can act to limit losses. This is one reason why all option writers have reason to monitor the underlying stock very closely.
And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.
Expiration Risk
None. Since the goal of this strategy is to acquire stock, the investor should welcome an assignment at the option’s expiration.
Profit/Loss:
In a short-term sense, the potential profit (from the put option itself) is very limited, while the potential losses are substantial. The premium earned is comparatively small compensation for accepting the large downside risk of a stock owner. If the stock falls to zero, the put writer is obligated to buy a worthless stock at the strike price.
Still, this short-term view gives an incomplete picture of the risks and rewards. It is perhaps more appropriate to compare this strategy to buying the stock outright, since the goal of stock ownership is the same.
The cash-secured put does somewhat better if assignment occurs. The put writer gets a better purchase price than the original stock price. The ‘discount’ consists of the original out-of-the-money amount, if any, plus the premium received. Both investors face the risk of the stock’s falling to zero, but the put writer’s premium income reduces the loss at every level. And if the stock rallies back, the put writer’s gains are better by the amount of the premium.
The outright stock buyer is better off than the put writer if the put is not assigned and the stock keeps rallying. Granted, the put writer keeps the T-Bill interest and the put premium. However, the stock has gotten even further away from the original target price and would now cost more to get into the portfolio.

Long Horizontal Spread - neutral strategy

Vertical Spreads

How Do You Set Up a Horizontal Spread?

Short Call Calendar Spreads ( credit spread )

buy a call in a front month
sell a call in a back or distant month

Long Call Calendar Spread ( debit spread )

sell a call in a front month
buy a call in a back month
profit from increasing implied volatility

Short Put Calendar Spreads ( credit spread )

buy a call in a front month
sell a call in a back or distant month

Long Put Calendar Spread ( debit spread )

sell a call in a front month
buy a call in a back month
profit from increasing implied volatility

Option Basics

Tips and Tricks

Investors are told repeatedly to be wary of short option strategies, and quite rightly so. Without question, they entail tremendous risk, far greater than the limited premium income. They are definitely not suitable for all investors and situations.
However, here is a short option strategy with a risk profile that is identical to the covered call. Though far from risk-free, covered call writing is considered a perfectly legitimate strategy for many equity investors.
The key here is the cash-secured put investor’s intent to acquire the underlying stock regardless of the near-term lows it might hit. So as long as the put writer is comfortable with assignment and the downside risks of the stock, this strategy isn’t inherently more dangerous than a covered call. Of course the risk is large if the stock is falls to zero. However, that risk applies to all stock owners and covered call writers, too.