Protective Put / Cash Secured Put

The protective put strategy is often employed by investors who want to hedge against downside risk while maintaining the potential for upside gains. It involves purchasing a put option for shares you already own, essentially acting as an insurance policy against significant stock price declines.

The Setup

Let’s say you own 100 shares of GreenTech, a renewable energy company currently trading at $50 per share. Concerned about potential short-term volatility but bullish on the long-term prospects, you decide to purchase a put option with a strike price of $45 that expires in three months, for which you pay a premium of $3 per share.

Who Should Consider It

This strategy is ideal for investors who are bullish on the long-term prospects of their stock but are concerned about possible declines in the short term. It is also suitable for those looking to protect unrealized gains without selling their shares.

Strategy Explained

By buying a put option, you acquire the right to sell your shares at the strike price regardless of how low the stock price may fall. This provides a safety net, ensuring that you can limit your losses if the stock price takes a significant downturn.

Breakeven Process

The breakeven point for a protective put is calculated by adding the premium paid to your original cost basis in the stock. If your cost basis was $50 per share and you paid a $3 premium for the put, your breakeven price becomes $53 per share.

Sweet Spot

The sweet spot for a protective put is when the stock price significantly exceeds the breakeven price at expiration. This allows you to benefit from all upward price movements while being protected against significant losses.

Max Profit Potential

The maximum profit potential is theoretically unlimited since the stock price can rise indefinitely. Your gains on the stock are offset by the cost of the put only up to the breakeven point; beyond that, all additional increases in stock price are pure profit.

Max Loss

The maximum loss is limited to the cost of the put premium plus the difference between the stock purchase price and the put strike price, if the stock goes to zero. In the GreenTech example, if the stock went bankrupt and became worthless, your total loss would be the difference between the stock price ($50) and the strike price ($45), plus the premium paid ($3), totaling $8 per share.

Risk

The risk lies in the cost of the put premium, which can be significant, especially for very volatile stocks. If the stock price remains flat or only slightly declines, you will still incur the cost of the premium, which can reduce overall investment returns.

Time Decay

Time decay is a critical factor as it erodes the value of the put option as expiration approaches, assuming the stock price remains above the strike price. This means the protective put is less effective as a short-term protective measure unless adjusted periodically.

Implied Volatility

High implied volatility increases the cost of the put due to the greater risk of substantial price movements assumed by the option. Conversely, if volatility decreases, the cost of purchasing protection reduces, but so does the value of the put you own.

Conclusion

A protective put is an effective strategy for investors looking to protect against downside risk while maintaining the potential for upside gains. It is especially useful in uncertain markets or when holding stocks with potential for high volatility. The key downside is the cost of the puts, which can detract from overall investment gains if the feared decline does not materialise.