Protective put options strategy

Submitted by admin on Thu, 11/25/2021 - 22:55

This technique entails supplementing a long stock position with a long put position.


When a long put option is attached to a long stock, the stock's value is guaranteed.
The strike prices chosen dictate when the downside protection 'kicks in.'
If the stock remains strong, the investor retains the upside potential.
(In reality, if the short-term outlook improves before the put expires, it may be resold to recuperate part of the premium paid.)
However, if the stock does go below the strike price, as many investors anticipated, the holder has various options.


One alternative is to exercise the put, which results in the stock being sold.
The strike price establishes the lowest possible departure price.
If the long-term picture has shifted negative, this may be the smart course of action.


If the worst appears to be past, investors who remain positive can hold the shares and sell the put.
The sale should return a portion of the premium paid and may even generate a profit.
If this is the case, it effectively decreases the stock's cost basis.

 

EXAMPLE

  • Long 100 shares AAPL stock
  • Long 1 AAPL 100 put

 

GAIN MAXIMUM


Unlimited


LOSSES ARE LIMITED TO THE MAXIMUM


Purchase price of the stock less the strike price minus the premium paid


If the investor remains apprehensive, the put may be kept until expiration to maximize the duration of protection.
Then it either expires worthless or is exercised, at which point the stock is sold.


The put option can offer significant protection against a downturn throughout the option's term.
The strategy's primary disadvantage is its high cost, which increases the bar for reaping upside rewards.
Investors who are not overly bullish may have more viable approach options.

Outlook


This investor is positive in general, but is concerned about a dramatic temporary decrease in the price of the underlying stock.


If the investor is also concerned about the longer-term prospects, he or she may choose to consider a covered call or selling the stock and purchasing another.

Summary


This technique entails supplementing a long stock position with a long put position.
Protective puts provide a 'floor' price below which an investor's shares cannot fall in value.


If the stock continues to rise, the investor profits from the increased value.
Regardless of how low the stock falls, the investor can execute the put to sell it at the strike price.

Motivation


This method protects investors against a brief decline in the value of the company.
The protective put buyer preserves the stock's upward potential while reducing its negative risk.


Several instances in which investors may consider defensive puts include the following:


Prior to an impending news event that might put a favored stock into a tailspin.

When it is critical to protect the value of a certain asset for a specified length of time; for example, to cover a down payment on a house or tuition expenses five months from now.

When a single stock accounts for a significant portion of an investor's portfolio.

When an investor is prohibited from selling a certain security for a specified length of time.

When a stockholder wishes to safeguard significant unrealized gains.


Variations


Except for the moment at which the stock is bought, the married put and protective put strategies are similar.
The protective put strategy is purchasing a put in order to hedge an existing position in a company.
If the put is purchased concurrently with the stock, the approach is referred to as a wedded put.
The term "synthetic call" is a colloquial name for this combo.

Maximum Loss


Maximum loss is capped.
The worst-case scenario is if the stock falls below the strike price.
It makes no difference how much below the strike price the put is; the put limits the loss at that moment.
The strike becomes the investor's 'floor' exit price, regardless of how low the market price may fall.


The overall loss is determined by the price at which the stock was bought.
If the stock was purchased at the same price as the option's strike price, the loss is limited to the premium paid for the put option.
If the acquisition price of the stock was bigger (lesser), the loss would be greater (lesser) by that amount.

Maximum Gain


The theoretical profits from this method are limitless.
The best-case scenario is for the stock price to increase indefinitely.


It makes little difference if the stock rises quickly if the put expires worthless.
A protective put is comparable to house insurance.
The asset is the major concern, and filing a claim indicates that the asset's worth has been diminished.
A homeowner would prefer that his or her insured home stay intact, even if it means forfeiting insurance premiums.
Similarly, a protected put holder would prefer to see the stock do well than to be forced to exercise the put's protection.

Profit/Loss


This technique preserves the stock's limitless upward potential while limits possible losses for the duration of the put option.


The strategy's profitability should be evaluated from the perspective of a stockholder, rather than in terms of whether the put option generates a profit.
The put is similar to insurance; it provides peace of mind, but it is desirable to avoid ever having to use it.


Consider the difference between a protective put and a straight long stock position.
In comparison to the unhedged stockowner, the protective put buyer pays a premium, which reduces the net return on the upside.
Returns will lag by the premium amount, regardless of how high the stock may rise.
However, in exchange for the hedge's cost, the put owner may exactly restrict the downside exposure, whereas the normal stockholder risks the whole cost of the stock.


If the investor is unwilling to pay the cost of a put hedge yet cannot accept the prospect of significant stock losses, a new approach may be required.

Breakeven


There is no one formula for determining the breakeven point of a strategy.
Profitability or loss is mostly decided by the acquisition price of the stock, which may have occurred at a considerably lower price in the past.


Assume that the stock was purchased at or around its current price.
If the unrealized gain on the stock is less than the premium, the approach would break even at the initial stock purchase price plus the put premium upon expiry.


Breakeven price equals initial stock price Plus premium

Volatility


Increases in implied volatility, on the other hand, would have a neutral to slightly positive effect on this approach.
On the one hand, the investor may place a higher premium on having put protection, since the market appears to believe a large move is imminent.


However, even if the investor disagrees with the market and has grown less concerned about the downside, an increase in implied volatility may be beneficial.
If the optimistic put holder chooses to terminate the hedge in order to reclaim part of the hedge's cost, increased implied volatility tends to increase the put option's resale value.

Time Deterioration


Time will have a detrimental effect on this method, all other factors being equal.
The hedge's protection expires.
In terms of market resale value, the put option tends to move toward its intrinsic value as the period expires.
Intrinsic value is zero for both at-the-money and out-of-money puts.

Assignment Danger


None. Risk of Expiration


None, as long as the investor is aware of the pre-established minimum exercise price.
Carrying the open position into expiry implies an intention to exercise the option if it is sufficiently in-the-money.
Investors who do not intend to sell their shares may need to sell in order to close their put option before to expiration if it is in-the-money.

Comments


A note to investors contemplating protective puts because they are unable to sell the stock immediately but are concerned about its prospects: it is critical to ensure that a put hedge is the optimal answer from all angles, including legal and tax considerations.
For instance, if employment-related stock sale limitations exist, a protective put may be seen just as objectionable as outright sale of the shares.
Additionally, depending on a variety of conditions, the IRS may consider a certain protective put to be the same as liquidating the stock, resulting in unfavorable tax repercussions.
Another reminder to obtain all pertinent facts first.