What is a 'Protective Put'
A protective put is a risk-management strategy that investors can use to guard against the loss of unrealized gains. The put option acts like an insurance policy — it costs money, which reduces the investor's potential gains from owning the security but also reduces his risk of losing money if the security declines in value. A protective put is also known as a married put.
BREAKING DOWN 'Protective Put'Implementing a protective put involves being long the underlying stock and purchasing a put option with a strike price that is near the underlying stock's current price. A protective put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty.
Profit and Loss
The maximum profit of a protective put is theoretically unlimited as the strategy involves being long on the underlying stock. The maximum loss is limited to the purchase price of the underlying stock less the strike price of the put option and the premium paid. The strike price of the put option acts as a barrier that the stock's price cannot fall below. The ideal situation in a protective put is for the stock price to increase, as the investor would benefit from the long stock position. The breakeven point of a protective put at the expiration state is equivalent to the current price of the underlying stock plus the premium paid for the put option.
Protective Put Example
If an investor purchased 100 shares of stock XYZ at $10 per share, and the price increased to $20 but he has not sold it, he has unrealized gains of $10. If he doesn't want to sell the stock yet (perhaps because he thinks it will appreciate further) but he wants to make sure he doesn't lose the $10 in unrealized gains, he can purchase a put option for that same stock (called the "underlying stock") that will protect him for as long as the option contract is in force. If the stock continues to increase in price, say, going up to $30, the investor can benefit from the increase. If the stock declines from $20 to $15 or even to $1, the investor is able to limit his losses because of the protective put.
Assume the investor purchased a put option on stock XYZ with a strike price of $15 for 75 cents. Therefore, the investor's maximum loss is limited to $575, or 100 x ($10 - $15 - $0.75), rather than $1,000 if he did not purchase the put option.