A protective put

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Hals' Blog Notes


A protective put is a financial strategy used by investors to protect their stock holdings from potential losses. It involves buying a put option on a stock that an investor already owns. This put option gives the investor the right, but not the obligation, to sell the stock at a specified strike price before or on a predetermined expiration date.

Here's an example to illustrate how a protective put works:

Let's say you own 100 shares of ABC Company, which is currently trading at $50 per share. You're concerned that the stock's price might decline in the near future, but you want to hold onto your shares for the long term. To protect your investment, you decide to purchase a protective put option.

You buy a put option with a strike price of $45, which is below the current market price of $50. The put option costs you $2 per share, and it has an expiration date of three months from now.

Now, here are a few scenarios that could play out:

Stock Price Rises: If the stock price goes up or remains above $50, you're not obligated to sell your shares at the $45 strike price. You only lose the cost of buying the put option ($2 per share), but your stock holdings have the potential to continue increasing in value.

Stock Price Stays the Same: If the stock price remains at $50, you again only lose the cost of the put option, but you have peace of mind knowing that you have some downside protection.

Stock Price Declines: If the stock price falls below $45, you can exercise your put option. Let's say the stock price drops to $40. In this case, you can sell your 100 shares at the higher strike price of $45, limiting your losses to $5 per share (the difference between the strike price and the market price). Without the protective put, you would have experienced a greater loss as the stock price dropped.

In summary, a protective put provides insurance against potential losses in a stock investment. It allows you to set a floor on the stock's price while still benefiting from any potential gains in the stock's value. However, this protection comes at a cost, as you have to pay for the put option.

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