A defensive put strategy, often referred to as a synthetic long call or married put, is purchasing the stock first, followed by one put at strike price A. When an investor uses this technique, they hope the stock will trade upward but also want to be protected in case it drops below strike price A, which would give them the option to sell the shares.
This tactic is typically used when a trader wants to protect their downside while still having the opportunity to gain on their upside because they are concerned about the market. In the event that a stock price declines further, the protective put functions as a price floor, limiting the amount an investor can lose. The investor is shielded from further losses after the stock drops below the protective put’s strike price.
How to Use the Protective Put
An investor who already owns stock runs the risk of suffering losses if the stock falls lower. However, by purchasing a protective put option, an investor is ensuring that if the stock continues to decline, they will be able to sell it at a set price, so limiting their losses.
The investor is establishing a price floor that safeguards their asset since they have a contract in place to sell a stock at a specific price, should they choose to do so.
The protective put functions as asset insurance, and like all forms of insurance, a premium must be paid in exchange for this security. The premium is determined by the investor’s desired price floor as well as volatility, which measures the risk that the stock price will continue to decline. Additionally, the insurance has a time limit; the longer the investor wants the insurance to last, the more expensive the protective put purchase price will be.
Strike Prices for Protection
An investor has a number of options when executing a protective put, including the level strike price to use and the expiration date. Typically, investors choose a put option that is out of the money. When the strike price is less than the stock’s current price, this occurs. As is the price difference between the current stock price and the level where the protective put adds insurance, this does not offer full protection. However, there is a lower premium for this defensive put.
Investors may also purchase at the money put if they are more concerned about a decline in stock price. The increased premium required for this level of insurance results in 100% protection from any losses thanks to the more active protective put.
Higher premiums are also a result of long-term protective puts.
Profit/Loss
The potential profit is limitless because the investor can keep making money as long as the stock trades at a higher price by owning the shares.
The maximum loss is determined by subtracting the stock price from the long put and then adding the put’s purchase price. The maximum loss, for instance, would be Rs 6.50 if the stock was trading at Rs 100 and the investor bought a 95-strike put for Rs 1.50.
Breakeven
The stock price plus the put price represents the protective put’s breakeven point. For instance, if the stock price is Rs 100 and the put price is Rs 1.50, the stock would need to increase by Rs 1.50 to break even, or Rs 101.50.
Example
If XYZ is trading at Rs 100 and is anticipated to rise in value during the following three months, a trader might purchase the stock and a put option with a 95-strike price for the sum of:
- 100 shares of XYZ stock are purchased for Rs 100.
- For Rs 1.50, purchase 1 XYZ 95-strike price put.
The investor will make Rs 5.00 on the shares if the stock trades up to Rs 105 at expiration, but because they spent Rs 1.50 on the put, they will only make Rs 3.50 overall.
The trader will execute the 95-strike price put and sell the stock at Rs 95 if the stock price falls to Rs 91 by expiration. As a result, they would have suffered a loss of Rs 5.00 on the stock and a loss of Rs 6.50 overall because they paid Rs 1.50 for the protective put.
Conclusion
When purchasing a stock or adding a protective put to an existing stock position, the only reason to acquire one is to reduce potential downside losses.
The value of the put grows along with an increase in implied volatility, therefore an investor who is long a put benefits from an increase in implied volatility. The put would lose value and damage the investment if implied volatility fell.
For a novice who wishes to get insurance for their long stock position, this is a great technique. It is crucial to comprehend every facet of the trade and how it may effect the position’s profit or loss before engaging in any options strategy.
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