A protective put is also known as a married put. This is a fundamental and widely used options strategy employed by investors who own the underlying stock and want to protect themselves against potential downside risk while still retaining the potential for upside gains. It essentially acts like an insurance policy for your stock holdings.

Core Concept:

A protective put strategy involves buying a put option on a stock that you already own. The put option gives you the right, but not the obligation, to sell your shares of that stock at a specific price (the strike price) on or before a specific date (the expiration date). By purchasing this put option, you are essentially setting a floor on the price at which you can sell your shares, regardless of how low the market price might fall.

Components of a Protective Put:

1. Long Stock Position: You must already own shares of the underlying stock. The number of shares should typically match the number of shares covered by the put option contract (usually 100 shares per contract in the U.S.).

2. Long Put Option (Buy to Open): You buy a put option on those same shares with a specific strike price and expiration date.

How it Works (Mechanics):

Consider an example: Suppose you own 100 shares of Stock XYZ, currently trading at $50. You are concerned about potential near-term downside risk but want to hold onto the shares for potential long-term gains.

• Action: You buy one XYZ $45 put option with a three-month expiration for a premium of $2.00 per share (total cost of $200 for one contract).
• Coverage: You own the 100 shares of XYZ, which the put option gives you the right to sell at $45.

Possible Outcomes at Expiration:

1. Stock Price Above $45 (e.g., $55):

   • The $45 put option expires worthless because it is out-of-the-money. You would not exercise your right to sell at $45 when the market price is $55.
   • Your Outcome: You retain ownership of your 100 shares, which have appreciated in value. Your net profit is the gain in the stock price minus the premium you paid for the put option ($5 gain per share – $2 premium per share = $3 net gain per share, or $300 total).
   • Your Protection: The put option provided peace of mind against a price decline.

2. Stock Price at $45:

   • The $45 put option expires at-the-money. You would likely let it expire worthless as selling at $45 is the current market price.
   • Your Outcome: Your stock position is at its protected level. Your net result is a loss equal to the premium paid for the put option ($2 per share, or $200 total).

3. Stock Price Below $45 (e.g., $40):

   • The $45 put option is in-the-money. You have the right to sell your shares at $45, even though the market price is $40.
   • Your Outcome: You would exercise your put option, selling your 100 shares at $45, receiving $4500. Your initial stock was worth $4000. Your loss on the stock is $500. However, you spent $200 on the put option. Your net loss is $500 (stock decline) + $200 (put cost) = $700.
   • Your Protection: The put option limited your losses. Without the put, your loss would have been $1000 ($50 – $40 per share). The put “insured” you against further declines below $45.

Profit and Loss Profile:

• Maximum Potential Loss: Limited to the difference between your original stock purchase price and the put option’s strike price, plus the premium paid for the put. In our example, if you bought the stock at $50 and the put has a $45 strike with a $2 premium, the maximum loss is ($50 – $45) + $2 = $7 per share (or $700 total). This occurs if the stock price falls below $45 at expiration.

• Maximum Potential Profit: Theoretically unlimited (just like owning the stock outright), minus the premium paid for the put option. The put option doesn’t cap your upside gains.

• Breakeven Point: Your original stock purchase price plus the premium paid for the put option. In our example, $50 (stock cost) + $2 (put premium) = $52. The stock price needs to rise above $52 for the entire position (stock + put) to be profitable at expiration.

Why Use a Protective Put?

• Downside Protection: The primary reason is to limit potential losses on a stock you own. It acts like insurance against a price decline.
• Hedging: It hedges your long stock position, providing a safety net.
• Peace of Mind: It allows you to hold onto a stock you believe in long-term without being overly concerned about short-term market volatility.
• Defined Risk: It transforms an investment with potentially unlimited downside risk into one with a known maximum loss.
• Flexibility: You retain the potential for upside gains if the stock price increases.

Key Considerations:

• Cost of Protection (Premium): The main drawback is the cost of buying the put option. This premium reduces your potential profits.
• Expiration Date: The protection only lasts until the expiration date of the put option. If you want continued protection, you will need to buy another put.
• Strike Price Selection: The strike price of the put determines the level of protection. A put with a strike closer to the current market price will offer more immediate protection but will also be more expensive (higher premium). A put with a lower strike price will be cheaper but will only protect you if the price falls further.
• Time Decay (Theta): Put options are decaying assets. As the expiration date approaches, the time value of the put option erodes. This works against the protective put holder if the stock price doesn’t decline.
• Volatility (Vega): Changes in implied volatility can affect the price of the put option. Generally, an increase in volatility will increase the value of the put (benefiting the holder), while a decrease will decrease its value.

In Conclusion:

A protective put is a valuable strategy for stock owners who want to safeguard their investment against potential downside risk while still participating in potential upside gains. It involves buying a put option on the stock you own, effectively setting a floor on your selling price. While it comes at the cost of the premium paid, many investors find this cost worthwhile for the peace of mind and defined risk it provides, especially during periods of market uncertainty or when holding onto a stock with significant unrealized gains. Understanding the relationship between the stock price, the put’s strike price, the premium, and the expiration date is crucial for effectively utilizing this strategy.