Protective Put Explained

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Protective Put Explained

An investor who purchases a put option while holding shares of the underlying stock from a previous purchase is employing a “protective put.”

Market Opinion?

Bullish on the Underlying Stock

When to Use?

The investor employing the protective put strategy owns shares of underlying stock from a previous purchase, and generally has unrealized profits accrued from an increase in value of those shares. He might have concerns about unknown, downside market risks in the near term and wants some protection for the gains in share value. Purchasing puts while holding shares of underlying stock is a directional strategy, but a bullish one.

Benefit

Like the married put investor, the protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the lifetime of the put contract, unless he sells his stock. At the same time, the protective put strategy serves to limit downside loss in unrealized gains accrued since the underlying stock’s purchase. No matter how much the underlying stock decreases in value during the lifetime of the protective put option, the put guarantees the investor the right to sell his shares at the put’s strike price until the option expires. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at both a time and a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price at the strike price, and control over when he chooses to sell his stock.

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss: Limited
Strike Price – Stock Purchase Price + Premium Paid

Upside Profit at Expiration: Gains in Underlying Share Value Since Purchase – Premium Paid

Potential maximum profit for the protective put strategy depends only on the potential price increase of the underlying security; in theory it is unlimited. If the put expires in-the-money, any gains realized from in an increase in its value will offset any decline in the unrealized profits from the underlying shares. On the other hand, if the protective put option expires at- or out-of-the-money the investor will lose the entire premium paid for the put.

Break-Even-Point (BEP)?

BEP: Stock Purchase Price + Premium Paid

Volatility

If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion of this bullish option strategy.

Time Decay?

Passage of Time: Negative Effect

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The time value portion of an option’s premium, which the option holder has “purchased” when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.

Alternatives before expiration?

The investor employing the protective put is free to sell his stock and/or his long put at any time before it expires. For instance, if the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining.

Alternatives at expiration?

If the put option expires with no value, no action need be taken; the investor will retain his shares. If the option closes in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put’s strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on the option’s last trading day. The premium received from the long option’s sale will offset any financial loss from a decline in underlying share value.

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Married Put Explained

Married or Protective puts are helpful when you want to protect the profits made from a stock, but do not want to sell it as of now to lock in the profits.

Married or Protective puts are also helpful when you bought shares and fear that the stock value may fall – but for some reason you do not want to sell the stock. Married puts will help in case the stock actually falls.

Here is a graph of married puts. If stock falls below “A” the protective puts will save the investor from losses in the stock.

Let me now explain in details.

You hold quite a lot of shares of a company and some bad news comes in about the company or about equities in general and you fear that your shares’ value may now tank. What do you do? You have two options:

1. Sell the shares at a loss, or
2. Buy ATM/OTM put of the same company.

Option 1 is pretty easy, but mostly you will lose money. Remember markets get the news before retail investors like us get. So even before you can trade, the markets will price the shares of the company you own at appropriate levels which almost always means you will be at a loss or may be breaking even (if you bought the shares at a great price.)

Even if you are not in a loss, one thing is pretty sure you lost a great amount of profits that you could have made had you sold the shares when they were at a higher level. Unfortunately greed came in and you kept it on hold. �� Well don’t worry, it happens with everyone. Nothing to feel guilty about it. If you are still in profit, my advice is that you should get out, and re-enter at a lower levels. The problem is how on earth you know if it will ever go more down and where to re-enter?

Timing the market is extremely difficult if not impossible. (Actually impossible, but they say nothing is impossible so ��

You can however protect further downside of the stock by a simple strategy called married puts. Which takes us to the second option. Buy ATM/OTM put of the same company.

Note: Married puts are useful if you have a lot at stake in that particular stock, at least 2-3 lakhs or equivalent to its leverage in futures and options. For example right at the time of writing this article HDFC Bank is trading at Rs. 588.00 and let us suppose you bought 500 shares of HDFC Bank at 590.00. So your total investment is 500*590 = Rs. 295,000.00. The markets are falling – especially the banking sector. You fear that HDFC Bank may also fall and so you may suffer a loss, but you want to hold the stock and don’t want to sell right now and not lose money too.

You can then buy a put option of HDFC Bank to protect your losses from the downfall. Now if HDFC Bank falls, you need not worry as the put you bought will also increase in value and you can sell it at an appropriate level to realize a profit. Now your buying cost of HDFC Bank will come down due to this profit.

Three things can happen when in a married put strategy:


1. Prices moves down:
You profit from the put bought. Your cost of buying the stock comes down.
2. Prices remain at the same level: Put expires worthless. You lose the premium paid to buy it. (Worst situation.)
3. Prices move up: You profit on the stocks bought. However you lose money on the puts bought. If prices move beyond the breakeven point you will make money. The premium paid to buy the puts should be added to the cost of buying stock. This is your breakeven point. Anything beyond that is your profit.

Great. But what is the risk?

The risk is if HDFC Bank shares stays at the same level or move up. The worst situation is when they stay at the same level. Your puts will expire worthless and you will lose whatever you paid as premium to buy them. If the shares move up, you will gain some from the up move but your puts will get lower in value as the stock price moves upwards. But after your breakeven points you should be in profits.

When is a married put helpful?

You should go for married put when you are certain that the stock price of the company you hold shares in will fall in value. And you should also know the maximum risk you are wiling to take. To make married puts work its best, it is best to buy ATM or just OTM puts. If you buy too far OTM puts they may be cheap but will not increase in value fast and may actually expire worthless even if the share price drops. This will be a double whammy. You lose money in shares and you will also lose money you invested in puts as well. As in joke they will become divorced puts. �� Rather your expression will be ��

Yes taking a married put decision can bring rewards, but the risk is definitely there. You may ask why not sell futures of the same company when the stock price is going down.

Yes you may be right. Yes there are no premiums to pay and the cash also comes from the collateral from the same shares. You can use your collateral to buy options as well but at least you know your max loss when buying options. In futures you have no idea as it can be unlimited loss, so using collateral money in not a good idea.

Selling future is a better option if the stock price stays there or goes down. However what happens if there is some good news and the stock opens gap up the next day morning? You will make money in stocks you hold, but lose the same amount of money in the future. Your buying cost of the stock will go up. Unfortunately you will have to pay this as MTM (mark to margin) and if you don’t have cash your broker may sell some of your shares to pay for the losses you incurred in the future. Not a good situation to be in.

With married puts you know exactly how much you are going to lose. And if your view was wrong you may actually sell the put and restrict your losses.

It is your call, but experts always say married puts not married futures. So there is something to it.

Important Note: If you are not sure of the movement or if you think there will not be a significant drop in the share value do not attempt a married put. You may lose the premium you paid.

Protective Put

(also known as married put) is an option strategy in which an investor purchases a put option to guard against any loss on the underlying asset which he already owns. Protective put is like insurance against loss on the underlying asset.

While protective put and married put are essentially the same in concept, in protective put the option buyer already owns the underlying asset, while in married put he invests in both the underlying asset and the put option on that asset simultaneously.

Investors buy protective put when they expect the underlying stock to increase in value but at the same time they want to remove any downside risk.

Formula

Since a protective put is made up of the underlying asset and a put option on the asset, the value of the whole position must be the sum of both components as calculated by the following formula:

Value of a Protective Put = UT + max[0, X − UT]

Profit at expiration of a protective put equals the difference between the price of the underlying asset at the expiration and the price at the inception of the strategy plus the payoff from the put option minus the premium paid on the put option. This is summarized in the following formula:

Payoff from a Covered Call = UT − U0 + max[0, X − UT] − Premium

Where, UT is the price of the underlying asset at the exercise date, U0 is the price of the underlying asset at the inception of the strategy and X is the exercise price

Example

Jonathan Wong bought $100 shares of Citigroup Inc. (NYSE: C) for $30 in October 2020. The stock is currently fetching $50 per share and he is quite happy with his pick. He thinks it is more likely that the stock will go up even further in next few months. But to guard against the possibility of any drop, he bought put options on Citigroup stock. He paid $5 per option and they carry an exercise price of $50 per option.

Discuss his profit from the position if Citigroup stock price at the exercise date is (a) $100, (b) $80, (c) $50, (d) $20, and (e) 0

If Citigroup stock price at the exercise date is $0, the value of his option will be $50 [= max[0, $50 − 0]]. His total profit from the whole strategy will be -$500 as calculated using the formula below:

Profit on protective put if Citigroup stock price is 0 = 100 × ($0 − $50 + max [0, $50 – $0] – $5)

Below is the calculation of profit from the strategy at the other prices:

Profit on protective put if Citigroup stock price is $20
= 100 × ($20 − $50 + max [0, $50 − $20] − $5) = -$500

Profit on protective put if Citigroup stock price is $50
= 100 × ($50 − $50 + max [0, $50 − $50] − $5) = -$500 = -$500

Profit on protective put if Citigroup stock price is $80
= 100 × ($80 − $50 + max [0, $50 − $80] − $5) = -$2,500

Profit on protective put if Citigroup stock price is $100
= 100 × ($100 − $50 + max [0, $50 − $100] − $5) = -$4,500

The illustration just validates the plot given below for profit on protective put.

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