If you have been investing in stock, indexes, or ETFs for a long time, you may have seen the market feels volatile most of the time. Therefore you may have got a fear that the stock may experience a downturn. But at the same time, these securities are your long-term holdings and you don’t want to sell them. In such a situation you could consider the Protective PUT strategy also known as the married put. In this blog, we are going to discuss the Protective PUT which is one of the options trading strategies. This strategy is used to cap the downside risk of a long stock position through the purchase of a PUT. So let's get into it.
A Protective Put or a married put is when you combine a long put option against at least a hundred shares of stock in an attempt to completely reduce or eliminate the risk of a long stock position below a specific price. You pay a premium to buy the PUT option but you can look at it as buying insurance for your stock, index, or ETF also known as the underlying. If the price drops the PUT provides protection but does not limit the upside potential of your stock, index, or ETF.
The Protective PUT is a relatively easier strategy and involves buying one PUT option for every 100 shares of stocks that you own. Buying a PUT gives you the right to sell your stock, index, or ETF at a set price called the strike price up to expiration. If you own a hundred shares of stock and you buy a PUT against those shares you effectively lock in a maximum loss equal to the strike price of the PUT, because in the worst-case scenario if the stock price goes to zero you will be able to sell your shares at the strike price of the PUT you purchased. You need to decide the selling price of your share and the time period to sell.
You can create a Protective Put ranging from a week with weekly options to several years with long-term leaps.
What Happens with Protective PUT at Expiration
After expiration, if your long put is In The Money (ITM) then the long put will automatically be exercised and you will effectively sell your shares at the strike price of the PUT.
If the long PUT is Out of The Money (OTM) then the put will expire worthlessly and you will lose the premium you paid for the PUT but you will keep your long shares.
Now in regards to assignment risk, the Protective PUT strategies do not include any short option positions. So there is no assignment risk.
Understanding Protective PUT with Example
Here is an example of using an Out-Of-The-Money PUT to protect your 100 shares of XYZ stock. A put is out of the money when the strike price is lower than the current underlying security price.
If a share is currently trading at 63 rupees, you buy a 60 strike put for 2 rupees, and let's say it expires in 30 days. This gives you the right to sell your stock at 60 rupees per share for 30 days, no matter how low the price drops. Before expiration, the stock and option will both move around a price.
If 30 days later the stock is higher than the PUT strike then your losses are easy to calculate. The PUT expires worthless. So you have lost the 2 rupees you have paid which is equal to 200 rupees for every PUT option. The option disappears and you can move on to the next trade. Just by figuring this 2 rupees loss to whatever the stock did during this time frame, you will have the net profit and loss for your account. For example, If XYZ jumps to 70 rupees from 63 rupees then stock profit is 7 rupees less the 2 rupees option premium (7-2=5) for a net gain of 5 rupees (or 500 rupees for 100 shares ).
Suppose at expiration 30 days later, the stock price is 55 rupees. You may have lost 8 rupees in the stock but the PUT option is now worth 5 rupees which gives you a 3 rupees option profit. Here is 3 rupees profit instead of 5 rupees because you have paid 2 rupees for the PUT. Your net damage taking into account the stop loss on an option profit is 5 rupees rather than the 8 rupees but here the positive side is that these 5 rupees is the maximum that your position could lose. At expiration, PUTs will be exercised if they are 1 penny in the money and your shares would be sold at 60 rupees. To avoid being exercised you simply sell your option before expiration.
Let’s see what happens if the stock drops far below the strike price. Let’s say the price dropped from 63 rupees to 25 rupees per share. This presents a 38 rupees loss on 100 shares but the 60 strike protective PUT is now In The Money and is worth 35 rupees. Netting your 38 rupees stop loss with the 35 rupees value of the PUT, you have a loss of only 3 rupees. The 3 rupees loss and the 2 rupees that you have paid for the PUT option give you the total max loss of 5 rupees which is 500 rupees per 100 shares. If you had not bought Protective PUT here, your loss would have been huge.
Downsides of Protective PUT
The expiration break even price is the stock purchase price plus the premium paid for the PUT. So one of the bad things about the protective put strategy is that since you are paying for that downside protection you are increasing the break-even price of your long stock position.
So now you need the stock price to increase up to the break-even whereas if you only buy a share of stock you just needed to increase its price from its current level to gain profit.
Since the cost of the PUT increases the break-even price of your long shares you need the shares to increase in price just to break even and therefore you have a less than 50% chance of making money by this strategy.
Though the protective PUT increases the break even price, it surely limits the losses. For buying a protective PUT you may need more money than buying only shares of the stock. But it is always advisable to buy a protective PUT to avoid losing all your capital beyond your capacity.