Insurance is something that everyone likes to have in their lives. Now, you must be wondering why I mentioned about ‘insurance’ while the subject is ‘Protective Put’ which is related to Stock Markets. The answer is that the concept of insurance can be applied to your stock market investments using instruments like ‘Options‘ as well.
What is Protective Put?
Now that we have a fair idea of what a put is, it would be interesting to know about Protective put.
If suppose an investor is holding 50 shares of a Company. He anticipates that the markets might fall or that the company might not do well in the coming days due to some internal failing. In order to put away with the fear of making a loss, he purchases a put option where the shares of company comprise the underlying security. To put it simply, when an investor purchases a put option for a certain stock while he is still holding shares of that underlying stock previously purchased is known as Protective Put. It is sometimes referred to as ‘Married Put‘, ‘Put Hedge‘, ‘Synthetic Long Call’ etc.
Its advantages are listed below.
Act as insurance when the markets are volatile
If an investor foresees the market to be bullish but still he wants to protect the value of stocks in his portfolio in case of a downturn, he uses the protective put option. It gives the right to the investor to sell the stocks he already owns at a strike rate. This strategy locks in gains and losses are reduced, but in case the stock advances higher, his total return is reduced.
For example considering the above mentioned scenario, even though the markets are doing good, the investor buys a Put of 100 shares of company (the underlying security) while having 50 shares of the same company in hand. In case the markets fall and the stock price falls, he is still at a profit as he owns the stocks of company at strike rate.
When dividend payments are anticipated.
The investor can still hold the stocks in a volatile market in case he foresees a forthcoming dividend payment. During the term that he holds the stock, protective put helps to minimize loss till the dividend is announced.
For example, if the investor anticipates that the company will be announcing dividends soon, he can buy a “put” for company till the dividends are announced. This way he is insured against the market fluctuations and profit by the dividends as well.
In case the shares are falling owing to some weakness in the company.
It definitely helps to minimize the loss and lock in profits. And additionally, the investor can still hold the shares if the company revives and rallies positively.
For example, the investor thinks that the company X has a weakness that might lead to stock price fall, say a leadership change, he can opt for the protective put. This will make him averse of any price drops and give him the benefit of holding the shares when the company recovers and perks up.
One can easily calculate the Breakeven point by adding the stock purchase price and the premium paid. After the expiration of the specified term of the put, the investor still holds the stock if he has not exercised his right to sell during the period.
Thus, protective put is just a way of hedging where the profits are maximum and losses is a minimum.