Options allow you to place directional bets on the market, hedge long or short positions in the underlying asset, and bet on changes in implied volatility. You can also use options to generate income.
One of the biggest uses of options is to de-risk a long position in stocks or other assets.
Explanation of Protective Put Strategy
A protective put is a relatively simple trading or investment strategy designed to avoid the risks associated with long positions.
For example, if a trader or investor is long 100 shares of ABC stock, they may look for ways to protect themselves against a price drop.
A protective put strategy simply involves buying a long put option that may appreciate in value if the stock price falls. Here’s a simple example:
Examples of protective puts
trader joe is bullish You own 100 shares of ABC stock, with an average purchase price of $40 per share.
The company has a big earnings call coming up in the next few weeks, and Joe wants to use a protective put to avoid downside risk to the stock.
Since the stock is currently trading at $45 per share, Joe decides to buy a two-month put option at $40 (that is, has a strike price of $42) at a premium of $4.
![Protective put option strategy](https://epsilonoptions.com/wp-content/uploads/Protective-Put-1024x669.jpg)
Examples of protective puts
If the earnings call is deemed bullish and the stock price rises, the put option can be sold back to the market at a loss or held until expiration.
If the stock price is above the option strike price of $40 at expiration, the option simply expires worthless and Joe loses the $4 premium he paid for the put.
However, if the stock price crashes, Joe’s put could rise in value and offset some or all of the stock’s losses.
If the stock price is below the option strike price of $40 at expiration, Joe has the right to sell his stock for $40, no matter how much the stock price drops.
For example, if the stock price falls to $35 per share, Joe’s loss is limited to the $4 option premium he paid per share.
when to wear
Protective puts are used to reduce the downside risk of long positions and can be used in a variety of situations. In the example used above, the trader wanted to hedge potential downside risks caused by a major earnings release.
In another scenario, a long-term investor may continue to buy long puts on stock positions that he believes could cause the stock price to skyrocket. volatility. Long put is also long vega.
In yet another case, when implied volatility levels are very low, traders or investors can buy puts, thus making options relatively cheap.
Advantages of Strategy
The main purpose of a protective put is to hedge the downside risk of a long position in the underlying asset.
Options can provide some protection to long positions and can also potentially be profitable if stock prices fall or implied volatility levels rise significantly.
Because put options are purchased, the risk of the put position is limited to the premium paid for the option.
Strategy cons
This strategy also has some drawbacks. Options have expiration dates, so they lose value over time while all other inputs remain constant.
Options close to the current stock price can also become prohibitively expensive, forcing traders and investors to buy puts far from their capital.
Puts far from the money can act as a hedge against large sells, but traders and investors still carry some risk to equities.
Puts of a few dollars may not provide enough value as a hedge against mild to moderate stock market losses.
crisis management
Risk management for protection puts can be accomplished in a number of ways.
If you are hedging a long position, you may be willing to simply hold the option until it expires, knowing that you will lose the full premium you paid.
Another way to manage risk is to sell puts to the market if they lose a certain amount of value. For example, some traders may decide to put a put back into the market if it loses half of its value.
Another way to manage risk is to delay issuance deadlines.
possible adjustments
There are several ways to adjust a long put position. A trader or investor can buy a put farther from money at first, and move the put closer to the stock price as the option gets cheaper as it expires.
Another method is to roll out a long put to a later expiration using the same or different strike prices. Traders and investors may even decide to spread long options by selling out-of-the-money puts on long options to lower their cost base.
Using a put to protect a long position in the underlying is a relatively simple position, but it comes with its own risks.
Traders and investors must decide how much risk to take on the stock price and how much to pay to hedge.
When used under the right circumstances, long puts can offer some protection to long positions, but that potential protection comes at a price.
Conclusion
A protective put limits the potential loss of a shareholding and does not affect the maximum return on the shareholding. However, like any other type of insurance, you have to pay a premium to buy a protected put. Over the long term, buying protective puts can lead to lower investment returns.
Traders and investors must decide how much risk to take on the stock price and how much to pay to hedge.
When used under the right circumstances, long puts can offer some protection to long positions, but that potential protection comes at a price.
About the Author: Chris Young has a degree in Mathematics and 18 years of experience in finance. Chris is British, but he has worked in the US and most recently in Australia. His interest in options was first sparked by the “Trading Options” section of the Financial Times of London. He was determined to pass this knowledge on to a wider audience and in 2012 founded Epsilon He Option.
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