SoFi

Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

A protective put is an investment strategy that uses options contracts to help reduce the risk that comes with owning a particular security or commodity. In it, an investor buys a put option on the security or commodity.

Typically, put options are used by investors who want to benefit from a price decline in a given investment. But in a protective put strategy, the investor owns the underlying asset, and is positioned to benefit if the price of the asset goes up.

The investor purchases the protective put, in this case, to help limit their potential losses if the price of the stock they own goes down.

An investor may use a protective put on various investments, including equities, ETFs, and commodities. But if the investment they own does go up, the investor will have to deduct the cost of the put-option premiums from their returns.

Recommended: How to Trade Options: A Beginner’s Guide

What Is a Protective Put?

Investors typically purchase protective puts on assets that they already own as a way of limiting or capping any future potential losses.

The instrument that makes a protective put strategy work is the put option. A put option is a contract between two investors. The buyer of the put acquires the right to sell an agreed-upon number of a given asset security at a given price during a predetermined time period.

Definition and Basic Concepts

There is some key options trading lingo to know in order to fully understand a protective put.

•   The price at which the purchaser of the put option can sell the underlying asset is known as the “strike price.”

•   The amount of money the buyer pays to acquire this right is called the “premium.”

•   And the end of the time period specified in the options contract is the expiration date, or “expiry date.”

•   In a protective put strategy, the strike price represents the predetermined price at which an investor can sell the underlying asset if the put option is exercised. However, the true floor price, the minimum amount the investor would effectively receive, is the strike price minus the premium paid for the option. This also accounts for the cost of protection.

For complete coverage in a protective put strategy, an investor might buy put option contracts equal to their entire position. For large positions in a given stock, that can be expensive. And whether or not that protection comes in handy, the put options themselves regularly expire — which means the investor has to purchase new put options contracts on a regular basis.

Setting Up a Protective Put

To set up a protective put, an investor must first own the underlying asset they want to protect. The investor purchases a put option contract for the same asset. This put option allows the investor to sell the asset at a predetermined price, known as the strike price, within a specific time frame.

Setting up a protective put involves:

•   Determining the Level of Protection Needed: Investors should evaluate how much of their position they want to protect. A full protective put strategy involves buying put option contracts to cover the entire position. However, for cost-saving purposes, some investors may choose partial coverage.

•   Selecting the Strike Price: The strike price represents the minimum price at which the asset can be sold if the put option is exercised. Higher strike prices provide more protection but come with higher premiums. Lower strike prices reduce premium costs but offer less downside protection.

•   Choosing the Expiration Date: The expiration date of the put option determines the duration of the protection. Shorter-term options are generally less expensive but require frequent renewal if protection is still needed. Longer-term options, while more costly, may offer stability for investors seeking extended coverage.

•   Purchase the Put Option: Once the strike price and expiration date are chosen, the investor buys the put option from the market. The cost of this purchase is the premium, which varies based on market conditions, volatility, and the specific terms of the contract.

By following these steps, investors can effectively set up a protective put to help manage downside risk while maintaining the opportunity for upside gains if the asset increases in value.

Uses of Protective Puts

Protective puts are primarily used by investors to mitigate downside risk while maintaining the potential for upside gains. This strategy can be applied across a variety of scenarios to suit individual investment goals and market conditions.

•   Portfolio Protection: Investors holding significant positions in a stock, commodity, or index can use protective puts to safeguard their portfolio against sudden price declines. By setting a strike price near the current value, they establish a “floor” that limits losses in the event of a market downturn.

•   Market Volatility Management: Protective puts can help investors reduce uncertainty during periods of heightened market volatility. If a stock begins to trade below the strike price of the contract, they can choose to exercise their option to sell the stock at that higher strike price.

•   Strategic Planning: Protective puts can also be part of a larger investment strategy, allowing investors to take calculated risks in other areas of their portfolio. With downside risk managed, they can explore opportunities for higher returns elsewhere without jeopardizing their core holdings.

•   Hedging Concentrated Positions: Investors with concentrated positions in a single stock or sector can use protective puts to hedge against adverse price movements. This is particularly useful for individuals or institutions holding stock grants, company shares, or positions they are reluctant to sell.

Overall, protective puts provide a flexible means of managing risk, ensuring investors can participate in potential market gains while limiting their exposure to significant losses.

Recommended: How to Sell Options for Premiums

Calculating and Choosing Strike Prices and Premiums

When implementing a protective put strategy, selecting the right strike price and premium is critical. These choices directly affect the level of protection, the cost of the hedge, and the potential returns. Understanding how to calculate and balance these factors helps investors tailor their strategy to their goals and risk tolerance.

Calculating Strike Prices

Investors should consider the following factors when choosing a strike price:

•   Risk Tolerance: A strike price closer to the asset’s current market price offers maximum protection but comes at a higher cost. Conversely, a lower strike price provides less protection but reduces the premium paid.

•   Market Outlook: If an investor expects minor fluctuations, they may opt for a lower strike price to balance cost and protection. For significant downside risks, a strike price near the current price may be preferable.

•   Investment Goals: Whether the focus is on preserving capital or limiting minor losses, the strike price should align with the investor’s specific financial objectives.

Premium Considerations

The premium is the cost of purchasing the put option. It represents the upfront expense for securing downside protection and affects the overall profitability of the strategy. Key considerations include:

•   Cost vs. Protection: Higher premiums may provide greater protection but can erode potential returns. Investors should weigh the cost of the premium against the likelihood and impact of a price decline.

•   Option Moneyness: Options can be in the money (ITM), at the money (ATM), or out of the money (OTM). ITM options have higher premiums but provide immediate protection, while OTM options are cheaper but only activate under significant price drops.

•   Time Decay: The time until expiration impacts the premium. Longer-term options, which are typically more expensive, provide extended protection, whereas shorter-term options have lower premiums but require frequent renewal.

By carefully calculating strike prices and evaluating premium considerations, investors can design a protective put strategy that aligns with their risk profile and financial objectives. Striking the right balance between cost and protection is essential to maximize the benefits of this strategy.

Real-World Examples and Scenarios

Protective puts are widely used by investors to manage risk across various market conditions. Examining real-world examples provides a practical understanding of how this strategy works and its potential outcomes in different scenarios.

Scenario Analysis

A protective put strategy can help an investor manage risk by limiting potential losses while maintaining exposure to gains. For example, if an investor owns 100 shares of XYZ stock, currently trading at $100 per share, and buys a protective put option (also for 100 shares) with a $95 strike price for a premium of $2 per share, the position will perform differently depending on the stock’s movement.

Let’s say the stock price drops to $85 near the expiration date. The investor can exercise the put option, selling the shares at the $95 strike price instead of the lower market price. Let’s say the stock price drops from $100 to $85. Without a protective put, the investor would face a $15 per share loss ($1,500 total for 100 shares). However, with a put option at a $95 strike price, they can sell at $95 instead of $85, recovering $10 per share. After subtracting the $2 premium paid, the net gain from the put is $8 per share ($800 total). This offsets part of the stock’s decline, reducing the total loss to $700 instead of $1,500.

On the other hand, if the stock price rises to $110, the put option will expire worthless, and the investor will lose the premium paid, which amounts to $200 (100 shares × $2). The stock’s price increase results in a $1,000 unrealized gain, and after deducting the $200 premium, the investor still sees a net gain of $800.

If the stock price remains stable at $100 until the expiration date, the investor will hold onto the shares without any price changes, but the $200 premium will be a loss. In this case, the protective put serves as a precautionary measure, providing peace of mind during the holding period, but without any real financial benefit.

These examples show how a protective put works to limit losses while allowing participation in upside potential. Although the premium represents a cost, this strategy is useful in managing risk, particularly in uncertain or volatile markets.

The Impact of Time Decay and Volatility

Time decay and volatility play significant roles in the pricing and effectiveness of a protective put strategy, impacting both the cost of the put option and its potential for profit or loss.

Time decay refers to the gradual reduction in the value of an options contract as it approaches its expiration date. As with all options, the protective put’s premium tends to decrease over time due to time decay, even if the underlying asset’s price stays stable. As the expiration date nears, the value of the put option typically declines due to time decay. This can impact an investor who wants to sell the option before it expires. However, if the investor holds on through expiration, its final value will depend on whether the underlying asset’s price falls below the strike price.

Volatility impacts the value of options by affecting their premiums. Higher volatility increases the potential for large price movements in the underlying asset, which can raise the cost of the protective put. Conversely, during periods of low volatility, premiums tend to be lower, making puts more affordable, but also potentially reducing the need for protection if the asset’s price remains relatively stable.

Advantages and Disadvantages of Protective Puts

As with most investing strategies, there are both upsides and downsides to using protective puts.

Pros of Using Protective Puts

Protective puts allow investors to set a limit on how much they stand to lose in a given investment. Here’s why investors are drawn to them:

•   Protective puts offer protection against the possibility that an investment will lose money.

•   The protective put strategy allows an investor to participate in nearly all of an investment’s upside potential.

•   Investors can use at-the-money (ATM), out-of-the-money (OTM) options, in-the-money (ITM) options, or a mix of these to tailor their risks and costs.

Cons and Potential Risks

Buying protective put options comes at a cost. There is limited upside potential, expenses involved, and may come with other tradeoffs that can impact your investing goals.

•   An investor using protective puts will see lower returns if the underlying stock price rises, because of the premiums paid to buy the put options.

•   If a stock doesn’t experience much movement up or down, the investor will see diminished returns as they pay the option premiums.

•   Options with strike prices close to the asset’s current market price can be prohibitively expensive.

•   More affordable options that are further away from the stock’s current price offer only partial protection and may result in further losses.

Alternative Strategies to Protective Puts

In addition to protective puts, investors have several other strategies to manage risk, such as covered calls and collar strategies.

A covered call involves selling a call option against a stock you own, which generates income through the premium received. This can help offset potential losses, though it caps the upside potential.

A collar strategy combines buying a protective put and selling a covered call on the same asset, limiting both downside risk and upside potential. This can be a cost-effective way to manage risk while still participating in some upside potential.

Comparing with Other Options Strategies

Each alternative strategy comes with its own set of trade-offs. While a covered call generates income through premiums, it limits the upside, as the stock is “capped” if it rises above the strike price of the sold call.

The collar strategy offers protection like a protective put but may be more cost-effective due to the income from the sold call, though it also limits potential gains. Investors should choose the strategy that aligns with their risk tolerance, investment goals, and market outlook.

When to Choose Alternative Strategies

Investors might prefer alternative strategies when looking to reduce the cost of protection or when expecting limited movement in the underlying asset. A covered call can be useful in a flat or slightly bullish market, while a collar strategy may be ideal for those seeking cost-effective protection without the full expense of a protective put. These strategies can also be suitable for investors who are more focused on income generation than on maximizing returns from significant price movements.

The Takeaway

Protective put options are risk-management strategies that use options contracts to guard against losses. This options-based strategy allows investors to set a limit on how much they stand to lose in a given investment.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

Photo credit: iStock/igoriss