Protective Put Strategy

Purab Kumar -

The Protective Put strategy is a risk management technique used by investors to protect their stock portfolio from adverse market movements. It is a popular strategy used by investors who want to limit their downside risk while maintaining their upside potential.

In this strategy, investors buy a put option on a stock they own, which gives them the right, but not the obligation, to sell the stock at a specified price (strike price) within a specified time period (expiration date). If the stock price falls below the strike price, the put option will increase in value, offsetting any losses in the stock price.

Let us take a closer look at the Protective Put strategy:

The Logic Behind the Protective Put Strategy

The Protective Put strategy is based on the principle of risk management. By purchasing put options, investors can limit their downside risk while maintaining their upside potential. The Protective Put strategy is a form of insurance against potential losses from owning stocks.

The strategy works on the premise that if the stock price falls below the strike price, the put option will increase in value, offsetting any losses in the stock price. The put option acts as a hedge against a significant decline in the stock price.

Investors who use the Protective Put strategy are willing to pay the premium for put options to protect their portfolios against market risk. They understand that the cost of the put option is a small price to pay for the peace of mind that comes with knowing that their portfolios are protected against significant market declines.

When to use the Protective Put Strategy?

Investors can use the Protective Put strategy in several scenarios, including:

  1. Protecting Profits: Suppose an investor has experienced significant gains from owning a particular stock or a portfolio of stocks. In that case, they may want to use the Protective Put strategy to protect their profits against a potential market downturn.
  2. Hedging Against Market Risk: Investors who believe the stock market is overvalued or uncertain about its future performance may use the Protective Put strategy to hedge against market risk. This strategy can help protect their portfolios against significant market declines.
  3. Buying a High-Risk Stock: Some stocks are inherently more volatile than others and carry a higher risk. If an investor decides to buy such a stock, they may use the Protective Put strategy to limit their downside risk.

Advantages of Protective Put Strategy

  1. Limiting Downside Risk: The Protective Put strategy helps limit the downside risk of owning stocks. By purchasing put options, investors can limit their potential losses in case the stock prices drop. If the stock prices decline, the gains from the put options can offset the losses from the stocks.
  2. Provides Flexibility: Investors can benefit from the Protective Put strategy in two ways. Firstly, it allows investors to participate in the stock market's upside potential while having limited downside risk. Secondly, it offers investors the flexibility to hold their stock position for a more extended period without worrying about any sudden price drops.
  3. Provides Peace of Mind: The Protective Put strategy gives investors a sense of security, knowing their portfolio is protected from significant market declines. This can help them make more rational investment decisions and avoid panic selling during a market downturn.

Disadvantages of Protective Put Strategy

  1. Cost: Buying put options can be expensive, and the cost of purchasing them can eat into the potential profits from owning stocks. Investors must factor in the cost of purchasing the put options while deciding whether to use the Protective Put strategy.
  2. Limited Gains: The Protective Put strategy limits the upside potential of owning stocks. If the stock prices rise, the gains from the stocks may be offset by the losses from the put options.
  3. Timing: Timing is critical when using the Protective Put strategy. If the put options expire before the market decline occurs, the investor may not benefit from the protection offered by the strategy.

Example of Protective Put Strategy

Suppose an investor owns 100 shares of Infosys, trading at INR 1500. To protect against any significant decline in the stock price, the investor buys a put option with a strike price of INR 1400, expiring in three months, for INR 50 per share.

If the stock price falls to INR 1300, the put option will increase in value to INR 100 per share, and the investor can sell the stock at the strike price of INR 1400. The investor would lose INR 200 per share on the stock but gain INR 50 per share from the put option, reducing the overall loss to INR 150 per share.

Conclusion

The Protective Put strategy is a useful risk management tool that investors can use to protect their stock portfolios from significant market declines. While the strategy has its advantages, investors must carefully consider the cost of purchasing put options and the timing of their expiration when deciding to use the strategy.

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