Fundamentals

Protective Put

A protective put involves buying a put option while owning shares of the underlying stock. Investors may use a protective put when they want to help limit potential losses while still participating in potential upside gains. Protective puts are commonly used as a form of downside protection because they allow investors to establish a minimum sale price for their shares during the life of the contract.

Outlook: Bullish
Use: Primarily used when investors want downside protection on shares they already own while maintaining upside exposure
Profit: You may profit if the stock price rises while the put option helps offset losses if the stock price declines
Loss: Losses are generally limited to the difference between the stock purchase price and the put strike price, plus the premium paid for the put option

Risks

Protective puts can help reduce downside risk, but they also increase the overall cost basis of the position because of the premium paid for the put option. While losses are limited below the strike price during the contract period, the cost of the put may reduce overall returns if the stock price remains stable or rises only slightly.

There is also the risk that the put option expires worthless if the stock price stays above the strike price through expiration.

Basic example

Let’s say you own 100 shares of FlyFit trading at $100 per share. To help protect against potential downside risk, you purchase one put option with a $95 strike price for a $3 premium.

Stock position: 100 shares at $100
The shares you already own and want to protect
Put option: $95 strike purchased for $3
The put option purchased to hedge the stock position
Contract price: $3 Long
Per-share price of the put option contract
Total premium paid: $3 x 100 = $300
Options have a contract multiplier, or the number of shares represented. The total premium paid is equal to the option premium multiplied by the contract multiplier. There may be add’l fees charged by your Brokerage.

The put option gives you the right to sell 100 shares for $95 per share through expiration.

Maximum profit and loss

The P/L calculations take into consideration both the stock position and the long put option.

Max loss: $800
Stock purchase price - put strike price + premium paid
Breakeven: $103
The breakeven is equal to the stock purchase price plus the premium paid for the put option
Max profit: Unlimited
The maximum profit is theoretically unlimited because the stock can continue rising in value.

Profit if...

FlyFit’s stock price rises above the breakeven.

Total profit: ($110 - $100 - $3) x 100 = $700
Difference between the current stock price and the stock purchase price, less the premium paid

In the scenario above, FlyFit’s stock price rises to $110 by expiration. The put option expires worthless, but the stock position gains $10 per share in value. After subtracting the $3 premium paid for the put option, the total profit is $700.

Loss if...

FlyFit’s stock price falls below the put strike price.

Total loss: ($100 - $95 + $3) x 100 = $800
Difference between the stock purchase price and the put strike price, plus the premium paid

In the scenario above, FlyFit’s stock price falls significantly below the $95 put strike price. While the stock position loses value, the put option allows you to sell shares for $95 rather than the lower market price. This limits the maximum loss to the difference between the stock purchase price and put strike price, plus the premium paid.

Brokerage services for US-listed securities and options offered through Public Investing, member FINRA & SIPC. Supporting documentation upon request.

The examples used above are fictional, and do not constitute a recommendation or endorsement of any investment.

Options are not suitable for all investors and carry significant risk. Certain complex options strategies carry additional risk. There are additional costs associated with option strategies that call for multiple purchases and sales of options, such as spreads, straddles, among others, as compared with a single option trade.

Prior to buying or selling an option, investors must read the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD).

Option strategies that call for multiple purchases and/or sales of options contracts, such as spreads, collars, and straddles, may incur significant transaction costs.