Buying a Protective Put

Protective Put OptionIn the last post, we discussed Married put option strategy. These strategies are also known as Hedging (protecting) strategy or profit protection strategy. These strategies help to protect yourself from losing money. Today we are discussing Buying a Protective Put strategy. The Married put and  Protective Put are essentially same but the difference is that in Protective Put the investors buys put option for the shares he already owns.
Let understand this strategy by taking an example, Suppose we purchased 100 shares of XYZ company at Rs 50 per shares,  the cost of shares is Rs 5000 (50*100). After four-month, the stock is now trading at Rs 80 per share. We have an unrealized profit of Rs 3000.
But currently, We are in the dilemma about future rise or fall of shares price. We have two options, first, sell this stock and book profit or hold and wait for future price rise to earn more.    
Buying a protective put option solve this dilemma. It protects your unrealized profits so that we don’t have to sell the shares. Remember a Put Option gives us the right to sell (but not the obligation) a certain stock at specified price on or before a specified date.  
Instead of selling shares we buy a Put option with strike price of Rs 80 at Rs 4 (it is premium or the price of put option). the put option cost us Rs 400 (4*100).
We insured ourselves against a loss if the stock price fell we still have the right to sell the shares at Rs 80. up until the day the put option expires.
Profit calculation (if price of stock falling)
We paid Rs 5000 for 100 shares of stock and Rs 400 for Put Option = Rs 5400
We sold 100 shares at Rs 80 at and received Rs 8000 in account
Total gain = Rs 8000- Rs 5400= Rs 2600.  

If the price of the stock rising we can sell the option we bought and buy another put option at the higher strike price.

Advantages of Protective Puts

  • Allows you to hold on to your stocks and participate in the upside potential while at the same time insuring against any losses
  • The cost to buy the insurance is relatively cheap considering how much money you are protecting

Disadvantages of Protective Puts

  • Cost of the Put option eats into your profit
  • The option has a limited lifespan (it expires) and has to keep being renewed (buying another option)
     

To be continued…….