You’re an investor who owns shares of a stock.
Just like other investors, you’re aware stock prices don’t only go up. In fact, at some point you’ve probably experienced a sell-off in the market or a sell-off of one of the stocks in your portfolio. There are certain options strategies that you might be able to use to help protect your stock positions against negative moves in the market.
There is an options strategy that may help you to protect against a decline in a stock’s price but doesn’t limit your upside potential if the stock price were to go higher. This is called the protective put strategy.
How protective puts work
1. You own 100 shares or more of a particular stock (or an ETF).
2. You want to maintain your ability to profit from the stock price rising, but you also want to protect the value of your stock if the price were to drop unexpectedly.
3. Buying a put option gives you the right to sell the stock at a lower price for some period of time. Usually you choose a put with a strike price that is below the current stock price but where you’d be willing to sell the stock if it were to decline.
Let’s take a look at some of the possible outcomes from this strategy. If the stock price goes higher, you would profit from the increase, but you would lose the money you paid to buy the put (the premium). If the stock price remains even, you lose the money you paid to buy the put, but you’re protected for a period of time against losses from a decline in the stock price.
However, if the stock price goes lower, your stock will sell at the strike price and you are protected against further losses to the downside.
Protect put trade example
Let’s assume stock XYZ is currently trading at $63 per share. You own 300 shares and you don’t necessarily want to sell your stock, but you want to limit your losses if it were to drop below $60. To hedge this position, you could buy 3 XYZ 60 puts for $.75 and pay $225 (3 X $.75 X 100 = $225) to have the ability to sell your 300 shares at $60 if the price of the stock were to drop below that amount. With the protective put, you pay a premium to have the right to sell your stock in case the stock price declined or there was a dip in the markets.
One question many traders may ask is, “How does someone choose what strike price to buy?” The answer may be simple. Ask yourself, at what price would you want to sell your stock if the price were to drop? While that may be a simple answer, it may not be easy! To help traders decide, there is a mathematical tool available to you. That tool is called Delta.
There are three common definitions of Delta:
- The expected change in the value of an option’s price for a $1 move higher in the stock price.
- The percentage of price risk of stock ownership that is currently represented in the option.
- The approximate probability that at expiration the stock’s price will be lower than the option’s strike price—and you would sell your stock.
However, it is the second definition that may really help you choose what put to buy. You may use the option’s Delta to determine what percentage of the current price risk of the stock you want to hedge using options. If you want to hedge a small percentage of the current price risk of the stock you could buy 20–25 Delta puts, meaning you are hedging 20–25% of your stock position. If you wanted to increase the percentage of your hedge, you could consider buying 30–35 Delta puts.
Once you’ve decided which puts you want to buy, and you have bought them, you need to monitor your position. It is important to note that you do not need to wait until expiration to see what happens. An important aspect of options trading is that you can always unwind, or close, your options position before expiration.† Just because there’s an expiration date attached to the options trade does not mean you have to hold it until that date. For example, if the stock goes higher and you no longer want to have the protection at the lower price through expiration, you could just sell the puts for a loss. Conversely, if the stock price drops but you do not want to sell your stock, you could choose to sell the puts.
The protective put is a powerful hedging options strategy that may help you feel a little more comfortable with market volatility knowing your stock is protected. However, do keep in mind that the security does come at a cost since you pay a premium to own the put.
† Refers to American-style options positions only.