What is a Protective Put?

//What is a Protective Put?
What is a Protective Put? 2017-10-09T07:41:43+00:00

Definition: A protective put is a long option that investors use as a hedging strategy against a potential decline in the price of the underlying asset. With a protective put, the option holder buys protection against a decrease in the market value of the underlying asset.

What Does Protective Put Mean?

What is the definition of protective put? In this strategy, investors are bullish on an underlying asset they already own, but they want to set a price floor to hedge against short-term losses.

On the other hand, with a protective put, investors have unlimited upside potential, whereas the worst-case scenario is that the stock price drops to $0, which is highly unlikely during the lifetime of the put option. The only shortcoming of protective puts is that investors have to pay a premium for the long put option, which raises the total cost of the underlying asset.

Let’s look at an example.

Example

On May 12, Lili owns 200 shares of a pharmaceutical company that trade at $165. The company is about to release its second quarter financial results. Lily has inside information that the results won’t be as good as in the first quarter. Therefore, she decides to buy a protective put to put insurance against the possibility of the market price declining due to second quarter results. She buys the protective put at a strike price of $80 and a premium of $300 – $3 per share as each option contract covers 100 shares.

If the market price drops to $65, Lily will realize a loss of 200 shares x ($80 – $65) = $3,000. Yet, Lily loses only the premium of $300 because she has set a price floor against a decline in the market value of the shares.

If the market price rises to $100, Lily will realize a gain of 200 shares x ($100 – $80) = $4,000. From this $4,000 Lily should deduct the premium of the put. Therefore, Lily’s gain is $4,000 – $300 = $3,700.

In fact, the protective put strategy limits the potential losses to the premium of $300 and leaves room for an unlimited upside potential.

Summary Definition

Define Protective Put: A protective put is an investment strategy where investors purchase options to protect their investments from a decrease in value.