Protective Put Options
Protective put options can be used to reduce the overall risk of one’s investment portfolio. After the economic crisis, many individual investors are hesitant to put their money back into the stock market. Thousands of investors lost a large portion of their wealth during the worst recession since the Great Depression. For many, the wounds from these dramatic losses are still healing, and many individuals are simply afraid to invest again. However, one option that can allow investors to put their money back to work in the market with a minimal amount of risk is the protective put option. Protective puts can be used to minimize the inherent risk involved with investing.
What Are Stock Options?
Stock options are considered derivative instruments because their value is derived from the underlying stock price. Put options grant the purchaser of the contract the right to sell the underlying stock at the strike price before the expiration date. For this right, the buyer pays the seller a fee, called a premium. Typically, one put is equal to 100 shares of the underlying company. Put options can be used to profit when the price of a stock decreases.
Additionally, puts can be used as “insurance” or to “hedge” a particular stock position. When an investor owns a specific security in his portfolio and simultaneously purchases a put option on the same security, the trade is called aprotective put. Since he owns the security, if the stock price declines, the value of the investor’s portfolio will decrease. However, the value of the put option will increase thereby offsetting some of the loss and minimizing risk. The buyer of the protective put option has the right to sell the stock at the strike price, prior to the expiration date, regardless of how far the stock price falls. Therefore, purchasing a protect put serves to limit risk of loss by the investor.
Real-Life Protective Put Example – Insurance
Basically, protective put options function in the same way as insurance. If you own homeowner’s or automobile insurance, you have essentially purchased a protective put. For clarity, let’s go through a real-life example.
Let’s say that you purchase a new car for $25,000. To prevent the loss of your investment, you also purchase an insurance policy on your new automobile worth $25,000 (strike price). Let’s assume the cost of this policy is $1,200 per year. You pay your insurance broker a $1,200 premium regardless of whether you file a claim or not. The life of this insurance policy is not unlimited. It has an expiration date, typically one year. After the purchase of this policy, you have successfully insured your car against dramatic loss.
Next, let’s walk through the possible outcomes. First, you drive safely during the course of the next year and have no incidents. After the one expiration period, you need to purchase another insurance policy, so you have effectively lost your initial $1,200 investment entirely. Secondly, if you’re unfortunate, you might have a major collision that renders your car unrepairable. In this case, you exercise your right to sell your automobile at the strike price of $25,000. Your insurance company must uphold its end of the contract and write you a check for $25,000. (Of course, this is an oversimplification, and your insurance company will claim the car is not worth the entire $25,00. But for simplicity, I’m assuming it will pay the entire original value).
This nets you $23,800 after subtracting the cost of the policy. Without insurance, if you have an accident, you lose your entire $25,000 investment. However, the insurance policy acts like a put option and minimizes your potential loss. Like homeowner’s or automobile insurance, the protective put is purchased for protection without the intention of actually using it.
Protective Puts for a Stock Position
Protective put options work in essentially the same manner for an investment portfolio. If an investor owns 100 shares of stock in the company GE, he can purchase a protective put to insure this position against dramatic loss. For example, the January 21, 2012 $22.50 put option is currently selling for $2.87. Since one contract is equal to 100 shares, the price must be multiplied by 100. Therefore, to purchase the right to sell 100 shares of GE stock at $22.50 per share until January 21, 2012, it would cost $287. So, what are the possible outcomes?
- First, on January 21, 2012, GE might be trading for $30 per share. In this case, your initial $287 premium paid to purchase the protective put is lost entirely. If you want another contract, you would need to purchase another contract.
- Second, on January 21, 2012, GE might be trading for $10 per share. In this case, the strike price of the put is higher than the actual stock price and therefore is considered “in the money.” The contract will have an intrinsic value of $12.50 and can be sold in the open market. Alternatively, you could exercise your right to sell the stock at $22.50 per share despite the current price of only $10 per share.
Protect Put Conclusion
Put options can be used to profit from a stock price decline or to protect an investor’s stock position against dramatic loss. Protective puts should be purchased when an investor is nervous that an ensuing stock price decline is forthcoming, but the investor does not want to sell his position and miss out on any further price appreciation. Protective puts act as insurance on a particular stock position and minimize risk.