What if you could buy protection against losses in the stock market. Protective put options offer this to investors. Investing in a recession or a bear market can be especially difficult, if you want to reduce your chance of incurring a loss. The recent volatility in the markets is causing many investors to question if they should sell their favorite companies and wait for a better day. Others are just resigned to ride it out, believing in the buy and hold approach. After all, that is what they have been told by their brokers, or read in various publications and books. Fortunately, there is a way to own shares of your best ideas by purchasing down side insurance that protects against potential losses. Buying put options that protect against a stocks decline offers this type of insurance.

In addition please see our article comparing use of protective puts vs. stop loss orders to provide down side protection.

What are Protective Put Options

To begin, let us review some of the basics. A put option gives the owner of the put the right, but not the obligation to sell 100 shares of the underlying asset, in this case stock, at a definite price known as the strike price until a specified expiration date. No matter how low the stock price falls, you still can sell the stock for the strike price until the option expires. When an investor simultaneously owns the common stock and a put option on that same stock, the position has limited downside risk during the life of the put. American options may be exercised at any time up to and including the expiration date. European options are only exercised on their expiration date.

For example, an investor owns XYZ stock that is currently trading at 52. He purchases an April 50 put option at $2.00. This put option gives the owner the right to sell 100 shares of XYZ stock at $50 per share up to the expiration date of the third Saturday in April, even if the share price falls to $25 per share. American options expire on the third Saturday even though the last day they are normally traded is the third Friday of the expiration month. The most the shareholder can lose is the 2 points on the share price and the 2 points he paid for the put option. A nice insurance policy that protects you against losses in the market.

What if the price of the stock rises to $75, rather than falls? You get to keep all the gains in the stock price minus the 2 points paid to buy the put option. The put gives you the right but not the obligation to sell shares of the underlying stock at the strike price. However, just like insurance you had to pay a premium to buy the put. If you hold on to the put until it expires, you will loose the entire premium while retaining the gain in the stock price. Of course, you could have bought back the put at a lower price, since the shares rose, which would help to lower the premium you paid for the insurance.

Investors employ a protective put strategy when they own shares of the underlying stock and are concerned about unknown, downside market risks over the next few weeks or months. The investor who uses a protective put retains all benefits of ownership (dividends, voting rights, etc.) during the life of the put contract, unless they sell their stock. At the same time, the protective put serves to limit downside loss over the life of the put. No matter how much the underlying stock decreases in value during the option's life, the put guarantees you the right to sell your shares at the put's strike price until the option expires.

Why not use a stop loss on your stock, rather than spending money to buy a protective put? If there is a sudden, significant decrease in the market price of the underlying stock, you have the luxury of time to react. Whereas a previously entered stop loss limit order on the purchased shares might be triggered at both a time and a price unacceptable to you, especially if the price of the shares then rebounds back up. The put contract has conveyed to you a guaranteed selling price at the strike price and control over when you choose to sell your stock. Moreover, investors can use put options with a strike price below, at or above the current trading price. This gives investors additional flexibility in their portfolio strategy.

The table below briefly describes the key factors that are important to understand regarding protective puts:

Different Strike Prices

One of the decisions an investor needs to make is what strike price they should use when buying a protective put. The strike price is the price you will receive if you decide to exercise your put option.  The higher the strike price the more premium you must pay to buy the put option.

Your choice of which strike price depends on your expectations of the price of the underlying shares. If you are bullish on the stock and expect it to rise, you might want to select a strike price that is above the current share price. On the other hand, if you bearish on the stock price over the near term, then you might want to select an in-the-money or at-the-money strike price.

The chart below shows the payoff curves of the stock combines with the put option at expiration for various alternatives. Depending on the strike price you have selected, the chart shows the stock position without put options, and hedged positions for in-the-money, at-the-money and out-of-the-money puts. The chart assumes the current share price is $50.  The in-the money strike price is $60 and the put is selling for $12.  The at-the-money strike price is $50 and the put sells for $5. The out-of-the-money strike price is $40 with the put selling at $2. These are examples and do not represent an actual stock or option prices.

Your choice of which strike price to select depends on your outlook for the stock over the time period of the option. Put options can be purchased for a few days to many months.

In the chart above, the profit is determined by the current stock price minus the premium paid for the protective put. The loss is calculated by the Strike Price - (Stock Purchase Price + Premium Paid). Notice that with the in-the-money put, you suffer the least loss if the stock drops sharply, but you also have the lowest gain if the stock rises. The in-the-money put offers the most down side insurance, since it provides the most protection against a loss. However, you will have the least gains if the price of the stock rises, since you must pay a higher insurance premium to buy the $60 put.

Let’s say, you are unsure which direction the share price might move over the next few weeks or months? Buying the at-the-money $50 strike put for $5.00 may offer a better. If you are uncertain about the direction of the stock, and you do not want to be wrong should the stock price make a big move in either direction, then the at-the-money strike put offers the most flexibility.

With the at-the-money put, if the stock rises to $60, you will have participated 10 point gain in the stock position, but will be out the $5 paid to purchase the put. Alternatively, if the stock declines $10 to $40, all you will lose is the $5 premium paid to buy the option, since coverage of the put will kick in as soon as the stock goes below $50. This reduces your maximum loss to $500 over the lifetime of the put option.

Now suppose you are more bullish on the stock, but want to protect yourself in case your stock experiences a sudden decline. In this case, you may want to cover your exposure by buying an out-of-the-money put. Looking again at chart above, notice that if you buy the out-of-the-money $40 strike put at $2 ($200 for one option), your protection starts at this lower strike price of $40. Your loss will be greater, since the put does not start to provide protection until the share price hits the $40 strike price. On the other hand, if the stock rises, your gains will be greater, since you only paid $2 for the option.

Who Should Use Protective Put Options

Any stockholder can use protective puts to reduce their risk. Essentially, there are two types of stockholders that find protective put strategies useful. First, is the investor who buys common stock and wants to buy some insurance to limit their losses in case they are wrong on the up trend in the stock. The second type is a long-term holder of the stock who does not wish to sell their shares. Maybe they have a significant gain already and expect the price to rise further. However, they wish to keep this gain, limiting their losses over a short-term time period of potential market weakness.

An investor who wants to buy a common stock, but would like to limit his losses should consider buying a protective put at the same time he buys the shares to provide down side protection. An investor who uses this strategy starts out with a position that has limited down side risk with almost the same profit potential. Most professional investors use puts rather than stop loss orders. This way they can avoid experiencing a brief drop in the price of the shares that are taken out by the stop, only to see the price of the shares rise again. The investor does not need to overreact to the sudden drop in the price of the shares, since they have the built in protection of the put.

For investors who wish to buy and hold stock for the long term, protective puts offer an excellent way to protect your profit should the shares move down. Maybe you have a large unrealized capital gain and do not want to take the gain at this time. Moreover, it is possible that the shares have more upside potential and you do not want to risk a decline. In this case, a protective put limits the risk of loss while allowing room for more upside appreciation.

The Bottom Line

With the market volatility we are now experiencing, stop losses are causing many investors to close out positions in companies that they would prefer to hold. Buying protective puts gives you the comfort level you need to hold individual securities, since you have purchased insurance against large losses. A protective put strategy may be viewed as more conservative than a simple stock purchase since a put is held against an underlying stock position limiting downside risk. This strategy provides a guaranteed selling price as its primary benefit. You know at what price the shares can be sold no matter how low the stock's price drops. On the other hand, the protective put does not place a cap on how high the stock may be sold. As a result you enjoy unlimited upside profit potential as the price of the underlying stock continues to increase. As long as the investor owns the shares he continues to receive any dividends paid to shareholders.

As with any long option position, you must pay a premium for the protective put and its many benefits. This increases the break-even point for the underlying shares that you own equal to the combined cost of the stock and the put. If at any point while owning the put the investor decides that further protection on the shares is not needed, the put may be sold at its current market value. If the price of the underlying shares has fallen, you may be able to book a profit on your put trade and you still own the underlying stock. Protective puts offer important advantages over just using stop loss orders. It will pay you to learn how to use them, especially in these volatile markets.

If you want to learn more about using options consider reading Options Made Easy: Your Guide to Profitable Trading (2nd Edition) by Guy Cohen. It is a good way to help you to get started learning how to use put options to reduce your down side risk.

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