Who Should Consider Using Protective
Puts?
- A stock-owning investor who doesn't want to sell the shares
because they may increase in value, but wants to protect his
unrealized profits (if any).
- An investor who is considering a stock purchase but at the
same time is concerned with downside risk.
Today's investors are often confronted with
uncertainties about the stock market. During bull markets they might
be worried about market corrections, and during bear markets that
their stocks could fall further. This uncertainty can lead to
reluctance to invest, and strong up moves might be missed. Just like
insuring other valuable assets like homes and automobiles, stock
positions can also be insured, and this is exactly what a protective
put accomplishes. Although not suitable for all investors, buying
puts to protect an existing stock position, or simultaneously
purchasing stock and puts, can supply the insurance needed for those
shares to overcome doubts about the marketplace. Typically, by
paying a put premium that is relatively small compared to the market
value of the stock, an investor knows that no matter how far the
stock drops he has a guaranteed selling price. By exercising the
put, underlying shares can be sold at the strike price at anytime
until the option expires.
Definition
Buying a protective put involves buying one put contract for every
100 shares of underlying stock already owned or simultaneously
purchased. This put guarantees the owner the right, but not the
obligation, to sell the shares at the strike price at any time until
the option expires, no matter how low the stock declines in value.
And just as with other forms of insurance the investor pays a
premium for this protection - the premium paid for the put.
The protective put's upside profit potential is unlimited as long as
the price of the underlying stock continues to rise. However,
purchasing a protective put in effect increases the purchase price
of the stock by the premium paid for the option contract. When the
underlying shares are ultimately sold, whether by exercising the put
after a stock price decline or by simply selling the shares after a
stock increase, the net price received will be the sale price less
the put premium paid. The break-even point for this strategy at
expiration can be calculated in advance as the stock's purchase
price plus the put premium paid.
Another benefit of the protective put is that the investor is in
total control of the sale of the protected shares. Since the
protection provided is a long option position, whether or not the
put is exercised, and the underlying shares sold, is entirely up to
the investor. If the underlying stock has declined below the put's
strike price before it expires, and the put is in-the-money with
intrinsic value, the put may be sold instead of exercised and the
shares retained. Regardless of the investor's decision at option
expiration, during the lifetime of the put contract the investor
continues to receive any dividends paid to stockholders as long as
the underlying shares are owned.
How to Use a Protective Put
Three common motivations for using a
protective put may be to protect:
- unrealized profits from previously purchased shares
- a new stock purchase
- previously purchased shares that have declined in value from
further downside loss
In the first case, an investor
purchased shares in the past that have increased in value over their
initial cost and so has unrealized profits. He considers the stock a
good investment, has a bullish outlook over the long term and wants
to continue owning the shares. However, he might be concerned about
either bearish sentiment in the broad market or the possibility of a
sudden market correction. A put purchase can at least partially
protect those profits.
In the second case an investor might be bullish on a given stock and
is considering a new stock purchase. However, he is also concerned
about the possibility of a temporary market decline. Buying a put
concurrently with the stock purchase offers this investor the
downside protection he wants from the onset of his stock position.
Finally, an investor owns stock that has declined in value and so
has unrealized losses. Because he still has a positive outlook on
those shares over the long term and does not want to sell them, he
wants to protect them from further downside risk. This investor is
willing to commit a relatively small amount of cash to his losing
stock position and so purchases a protective put.
In any of these cases, the degree of protection provided by the long
put depends on both the strike price chosen and an option expiration
month that reflects the investor's timeframe for potential downside
risk
Please note: Commission,
dividends, margins, taxes and other transaction charges have not
been included in the following examples. However, these costs can
have a significant effect on expected returns and should be
considered. Because of the importance of tax considerations to all
options transactions, the investor considering options should
consult with his/her tax advisor as to how taxes affect the outcome
of contemplated options transactions.
Example
An investor purchases 100 shares of ZYX stock at $52. If a
protective put isn't purchased, as soon as the stock drops below the
purchase price the investor will begin to lose money and the entire
$52 purchase price is at risk. On the other hand, if the stock price
rises the investor benefits from the entire increase without
incurring the insurance cost of the put premium.
Let's take a look at this investor's choices for purchasing
insurance on his stock holdings and consider three scenarios:
- the stock has increased in value and protection for
unrealized profits is purchased
- a put is bought at the same time the stock is purchased
- the stock has decreased in value and protection from further
loss is desired
ZYX shares increase from $52 to $67 -
ZYX put is purchased
In this case the investor has unrealized
ZYX stock profits of: $67 current price - $52 purchase price = $15 per
share, or $1,500 total. Protection of these profits is wanted for the
next several months, so the investor considers the purchase of a
three-month ZYX put contract. However, in the marketplace the investor
currently has a choice between buying a ZYX 65 put for $2.70 and a ZYX
60 put for $1.10. Either would offer insurance on profits, but to
different degrees, by guaranteeing a stock sale price no matter how low
ZYX actually declines.
ZYX 65 Put Purchased
If the ZYX 65 put is purchased the net cost would be $2.70 x 100, or
$270 total. If ZYX declines in price below the $65 strike price and the
put is exercised at expiration, the 100 underlying shares would be sold
at the strike of $65 per share. In this case the realized net profit on
the stock purchase would be: $65 strike price - $52 stock's initial
purchase price = $13 per share, or $1,300 total, less the $270 cost of
the put. As insurance in the form of a $65 put was purchased when the
underlying stock price was currently $67, the difference of $2 ($67
current stock price - $65 strike price) per share is given up because of
the decline in ZYX stock price. This $2, or $200 total for 100 shares,
could be considered the deductible for this insurance policy. The
result: a premium of $270 was spent to protect $1,300 of the $1,500
profit unrealized when the put was purchased.
ZYX 60 Put Purchased
Let's now compare the purchase of a ZYX 60 put for $1.10 when ZYX stock
is currently trading at $67. The total premium paid would be $1.10 x
100, or $110 total. If ZYX declines below the $60 strike price and this
put is exercised at expiration, the 100 ZYX shares would be sold at the
$60 strike per share. The realized net profit on the stock purchase
would be: $60 strike price - $52 stock's initial purchase price = $8 per
share, or $800, less the initial $110 cost of the put. As a 60 put was
purchased when the underlying stock price was currently trading for $67,
the difference of $7 ($67 current stock price - $60 strike price) per
share is given up because of the stock price decline. The deductible on
this insurance policy is therefore $7 per share, or $700 total. In this
case a premium of $110 was spent to protect $800 of the $1,500 profit
unrealized when the put was purchased.
In either scenario above, if at any point
before expiration the investor decides that further downside protection
for his stock is not needed the put may be sold, if it has market value,
and possibly at a profit. In this case the shares would be retained.
While owning the put the investor's upside potential profit remains
theoretically unlimited as the stock price continues to increase.
However, the cost of the put premium in effect increases the net stock
purchase price by the premium amount paid. In other words, if the ZYX
shares increase in price after the put purchase, and the put expires
out-of-the-money and worthless, when the shares are eventually sold the
realized profit over their purchase price will be less the put premium
paid for insurance.
ZYX shares purchased at $52 - ZYX put
purchased at the same time
This investor decides to buy a protective
put at the same time 100 shares of underlying are purchased at $52, and
feels the need for insurance on this stock over a 3-month timeframe.
There are no unrealized profits to protect, but downside price
protection for the shares is provided none-the-less. Profit potential on
the upside remains unlimited as ZYX shares increase in price. Available
3-month out-of-the-money ZYX puts are a $50 put trading for $1.90 and a
$45 put trading for $0.50.
ZYX 50 Put Purchased
If the investor buys 1 ZYX 50 put for $1.90 then the 100 shares bought
at $52 are protected below the strike of $50 per share, no matter how
low the stock price declines - effectively a $2 deductible for the
insurance provided. The downside maximum loss for this position is: $52
stock purchase price - $50 strike price plus the $1.90 put premium paid
= $3.90, or $390 total. If the price of ZYX stock is below the strike at
expiration the investor could exercise the put and sell the 100
underlying shares. The net sale price would be: $50 strike price - $1.90
cost of the put = $48.10, or $4,810 total. In this case the maximum loss
would be realized: $5,200 net stock purchase price - $4,810 net stock
sale price = $390. The investor would then have no position in ZYX stock
or option.
If at expiration the investor feels that ZYX will not decline further
then he could sell the expiring in-the-money put, which should have some
market value, and retain the 100 shares for possible profit in the
future. By doing this he could recoup some of the cost of the original
put protection, and any profit realized from the put's sale could at
least partially offset an unrealized loss seen on the shares at that
point.
On the upside the break-even point on the shares is a ZYX price of: $52
stock purchase price + $1.90 put insurance premium paid = $53.90. In
other words, the price of ZYX shares would need to advance above their
purchase price by the amount of the premium initially paid for the put.
Above that point, the net profit received from selling the 100 shares
will be less the $190 put premium paid.
ZYX 45 Put Purchased
This investor could have instead purchased the more out-of-the-money ZYX
45 put to insure his shares purchased at $52. The result is a larger
deductible of $7 ($52 stock cost - $45 strike), which means the shares
are only protected below $45. The potential downside loss would be
greater: $52 stock purchase price - $45 strike price plus the $0.50 put
premium paid = $7.50, or $750 total. On the other hand, the upside
break-even point would be lower: $52 stock purchase price + $0.50 put
insurance premium paid = $52.50. The trade-off for this lower priced
insurance policy is therefore less downside protection for a lower
upside break-even point.
ZYX shares decrease from $52 to $42
- ZYX put is purchased
This investor has seen a significant
decline in unprotected stock value from $52 to $42, but does not
want to sell the 100 shares. However, he is willing to commit a
small amount of cash to this losing stock position for protection
from further decline and decides to purchase a protective ZYX 40
put. In the marketplace a 1-month 40 put is trading for $0.50, a
2-month 40 put for $1.00, and a 3-month 40 put for $1.40. He decides
that buying the 3-month put for a total premium of $140 suits his
tolerance for further cash commitment, gives him the downside stock
price protection he wants, and fits his timeframe for possible
further decline.
This $140 insurance will protect the 100 shares previously bought
for $52 below the guaranteed sale price of the $40 strike. The
investor has already seen an unrealized loss of $1,000 from the
significant stock price drop from $52 to $42. But no matter how much
more ZYX declines in price, further downside loss is limited to: $42
current stock price - $40 strike price plus the $1.40 put premium
paid = $3.40, or $340 total. In other words, by purchasing put
protection the investor has stemmed a total loss on his original
$5,200 stock investment to a maximum of $1,000 plus $340, or $1,340.
The cost of the put, however, has resulted in a break-even point on
the original stock purchase of: $52 stock purchase price + $1.40 put
premium paid = $53.40 per share.
If at expiration ZYX has declined well below the put's $40 strike
price the investor may exercise the put and sell the 100 shares for
a net price of: $40 strike price - $1.40 cost of the put = $38.60,
or $3,860 total. This would represent a net realized loss from the
original $5,200 stock investment of the maximum $1,340.
Alternatively, if the investor decides the shares no longer require
downside protection at this point he could sell the put contract to
recoup some if its original cost or possibly make a profit. In this
case the shares would be retained. The investor would then be poised
to recoup some or all of the original stock investment if the price
of ZYX increases, or to possibly profit if its price rises high
enough.
For investors finding themselves with a losing stock position in
need of further downside protection there are strategies other than
the protective put that might be considered. Among them is the
"Stock
Repair" strategy.
Summary
The potential volatility of the marketplace can
present great risk to stock investors, but purchasing protective
puts can give investors the comfort level needed to purchase
individual securities. This strategy may be viewed as more
conservative than a simple stock purchase because as long as a put
is held against an underlying stock position there is limited
downside risk. The primary benefit of this strategy is that it
provides a downside guaranteed selling price. That is to say an
investor knows at what price 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 can be sold. The protective
put holder enjoys unlimited upside profit potential as the price of
the underlying stock continues to increase, and as long as the
shares are owned he continues to receive any dividends paid to
shareholders.
As with any long option position, an investor pays premium for the
protective put and its many benefits. The result is an increased
break-even point for the underlying shares that are owned 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 if it has market value,
and possibly at a profit.
Buying an at-the-money put or one of possibly several
out-of-the-money contracts that might be available can have
different advantages and risks. For most underlying stocks there
will be a listed put contract with a strike price and expiration
month that optimally fits the balance of risk vs. reward an investor
is looking for. Keeping in mind that protective puts do expire,
sometimes before they provide any insurance value, a put buyer might
turn to a LEAPS ® put contract which can have a lifetime of up to
three years. Alternatively, an investor might choose to "roll" a
shorter-term protective put position by selling an existing put
position and purchasing another with a different expiration month
and possibly a different strike price
