Are you optimistic about a stock’s long-term prospects but you may want protection in case its price takes a short-term hit? You might want to consider an options strategy called the protective put. It lets you see potential gains in a stock you own while also limiting your potential losses—in exchange for a cost to buy the option. Here’s the lowdown on protective puts.
What is a protective put?
A protective put is an options strategy that lets you determine the maximum potential loss you face when owning an asset like a stock. It involves 2 components: holding a particular stock and buying a put option on that same investment. You can buy a put on a stock you already own, or you can buy a put at the same time that you acquire a new stock (which is called a “married put”).
First, let’s break down what exactly a put option is. Buying a put gives you the right, but not the obligation, to sell shares of a specific stock at a predetermined price, called the strike price, before a set expiration date. A put buyer hopes the price of that stock goes down in price. The objective is for it to fall below the strike price of the contract to be “in the money," but also ideally below the “break-even point,” which is when the put starts to become profitable. The break-even point is a price below the strike price where you recoup your options premium (i.e., the cost of buying the options contract). Any price decline below the break-even point is potential profit for the put buyer.
A protective put can be thought of as an insurance policy against steep losses on a particular stock. Using a protective put doesn’t necessarily mean you’re bearish on that stock. In fact, investors typically use protective puts on stocks they believe will perform well over the long term. But if you’re worried about short-term price declines, a protective put can help limit losses during the life of the put contract.
How does a protective put work?
Before implementing a protective put, you want to have an outlook on a stock. For example, suppose you own a stock that you don’t want to sell because you think it could increase in value over the long term, but you think it might decline by some percentage in the next 2 months. You might consider looking for a put contract with a strike price near where you think the stock could fall with an expiration date 2 months away.
Assume you buy a protective put on the stock you own. If the stock falls below the strike price at any time during those 2 months, you can exercise your option and sell your shares for a higher price than you’d get on the market (and you would no longer limit your losses due to the protective put). On the other hand, if the stock doesn’t fall during those 2 months, you can simply let the option expire and hold on to your shares. You still benefit from the rising stock price. Your potential profit would be lower when you sell due to the option premium you paid for that protective put.
An example of a protective put in action
Let’s look at how a protective put might play out in a hypothetical scenario. Say on January 20th you own 100 shares of XYZ stock, which is trading at $62 a share. You’re bullish about the stock’s long-term prospects and do not want to sell the stock, but you’re also concerned that the company might miss an upcoming product launch deadline, potentially triggering a short-term dip in the stock price.
In the options chain, where options contracts are listed for purchase, you find a put on XYZ stock with a $60 strike price for a premium of $1. The put expires in 2 months. Since options contracts typically cover 100 shares of the underlying stock, buying one put will cover your current stake in XYZ stock, for a total premium cost of $100 (1 contract x $1 x 100 shares).
Suppose the company launches its product on time and XYZ stock rises over the next 2 months. In that event, you won’t exercise your option. You still benefit from those gains, minus the $100 you spent to buy the put. If XYZ stock stays flat for the next 2 months, you’d also let the put expire and be out the $100 premium you paid.
However, if the price of XYZ falls below the $60 strike price during the 2-month period, the put offers some protection from a move down by the underlying stock. Without a put, your investment would continue losing value as the stock price sank deeper and deeper. But adding the put means you’ve locked in the ability to sell your shares at $60 anytime before or at the contract’s expiration date.
Say XYZ stock drops to $50 over the 2-month period. If you sold without a put, you’d lose $12 per share, or $1,200. But with your put, your maximum risk is the 2-dollar difference between your $62 purchase price and your $60 sale price, plus the $1 you spent on the premium. Your loss ends up being $3 per share, or $300. That’s the power of the protective put: You keep most of your upside potential, while limiting your potential downside.
Benefits of a protective put strategy
- You may be able to limit your maximum risk on an investment. By choosing a strike price, a protective put can help limit how much you can lose on the underlying stock within a specific timeframe. If you’re concerned about a steep short-term decline, a protective put is insurance against losing more than you’re comfortable with.
- You still participate in the upside. Even though you have downside protection, you’re not obligated to exercise your option. If the stock price rises, you retain ownership of your shares—and exposure to any potential profits.
Disadvantages of a protective put strategy
- If a declining stock doesn’t fall to your strike price, you still lose out on the premium. Choosing a strike price requires careful consideration in a protective put strategy. Puts with lower strike prices are generally cheaper relative to puts with higher strike prices. However, choosing a lower strike price reduces the protection of the put because there is a lower probability of the stock falling below the strike price. In that case, you may not get the downside protection you expected, and you’re still out the money you spent on the premium. Puts with higher strike prices tend to have higher premiums, but they provide a greater chance that you can exercise the contract.
- Your returns may be lower on well-performing stocks. If a stock performs well and you do not exercise your option, the cost to buy the option will reduce your overall profit.
How to implement a protective put strategy
If you’re interested in implementing a protective put strategy, here’s how to get started:
- Open (or fund) a brokerage account
If you don’t already have a brokerage account, look for one with low fees and intuitive research capabilities. Once you’ve opened an account, transfer money into it to cover the cost of buying shares and paying premiums on any put contracts you want to buy.
- Apply to trade options, if necessary
Some brokerages require approval to trade options. At Fidelity, this involves completing an application about your finances, as well as your investing experience.
- Research investment options and start buying protective puts
If you want to buy shares and puts at the same time (married puts) use your brokerage’s resources to research stocks or ETFs you may want to own. Then, log in to your brokerage account, access the option chain, and enter the ticker symbol to find puts on that investment. The option chain lets you potentially compare several strike prices, expiration dates, quotes of the options, and option strategy views. You can trade right from the option chain. If you trade at Fidelity, use our Option Strategy Builder tool to help you build and place an options trade that matches your goals and outlook.