Protective Put

Definition

A protective put is an options trading strategy where an investor buys a put option for a stock they already own, providing insurance against a potential decline in the stock's price. This strategy allows the investor to maintain ownership of the stock while limiting potential losses, as the put option gives them the right to sell the stock at a predetermined price, thus acting as a safety net in case of adverse price movements.

5 Must Know Facts For Your Next Test

1. Using a protective put can limit losses while still allowing for potential gains in the underlying stock.
2. The cost of purchasing a put option reduces overall returns on the investment, but it serves as insurance against significant declines.
3. Investors typically choose a strike price for the put option that reflects their acceptable level of risk and loss.
4. This strategy is especially useful during periods of high market volatility when investors may want to hedge against potential downturns.
5. Protective puts can also be part of a broader investment strategy to manage risk and ensure more predictable outcomes.

Review Questions

• How does a protective put serve as a risk management tool for investors holding stocks?
  • A protective put acts as a safety measure for investors by allowing them to limit potential losses on stocks they own. When investors purchase a put option alongside their stock holdings, they can sell their shares at the strike price if market conditions worsen. This strategy enables investors to mitigate risk while still benefiting from any upward movement in the stock's price.
• What factors should an investor consider when selecting the strike price for a protective put?
  • When choosing the strike price for a protective put, an investor should consider their risk tolerance and investment goals. A higher strike price may provide more downside protection but comes with higher premiums, while a lower strike price could reduce costs but offer less protection. Investors also need to evaluate market conditions and their expectations for the stock's future performance when determining the most appropriate strike price.
• Evaluate the potential benefits and drawbacks of implementing a protective put strategy in an investment portfolio during periods of high market volatility.
  • Implementing a protective put strategy during times of high market volatility can provide significant benefits, such as reducing potential losses and offering peace of mind for investors. However, this strategy also comes with drawbacks, including the cost of purchasing put options, which can eat into profits if the stock performs well. Investors must balance these costs against their desire for downside protection and consider whether this approach aligns with their overall investment objectives.

Related terms

Put Option: A financial contract that gives the owner the right, but not the obligation, to sell an underlying asset at a specified price within a certain timeframe.

Call Option: A financial contract that gives the owner the right, but not the obligation, to buy an underlying asset at a specified price within a certain timeframe.

Strike Price:

The specified price at which an option can be exercised, representing the price level at which the underlying asset can be bought or sold.