Protective Put
The Protective Put Strategy, also known as a hedging put, is a hedging strategy were the holder of an underlying security buys it put option to hedge against a drop in the stock price of the underlying security. This is usually done in a one option to 100 shares ratio.
The protective put strategy is usually placed when the trader/investor still bullish on the stock feels there is uncertainty in the near future that may cause the stock to go down. The project but strategy is used as a means to protect the individual investors under a life gains on the shares owned.
Protective Put Risk Profile
Composition
Long the underlying security and long put options. Is considered the ‘opposite strategy’ of the covered call. This is a premium outlay position.
Risk/Reward
Max Reward: Unlimited Upside Potential
Max Risk: Limited to premium paid for put options bought.
Generally used to protect position in underlying asset from market correction.
Characteristics
The Protective Put position is a hedged position. The risk profile identical to one of a long call. Your maximum loss is limited to the premium paid for the option and you have unlimited profit potential to the upside.
The protective put is a premium outlay position so time decay works against us in this case. It’s equivalent to buying insurance for the underlying security.
This position can also be used to play a technical breakout of the underlying, where the investor is looking for an explosion to the upside.
Three things must happen for the protective put strategy to be effective:
1. We’ve got to be correct in direction of underlying asset.
2. We’ve got to be correct in out timing (remember this is a premium outlay position)
3. This must be a quick aggressive and volatile movement to really optimize this strategy
Important
A protective put is synthetically equivalent to a Synthetic Long Call. It is easy to see this by comparing risk profiles (image above).
Protective Put = Synthetic Long Call
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