What is a Protective Put Options Strategy?

Options trading is the most popular way to earn short-term gains. While the rewards are lucrative, the risk involved also tends to be higher. However, this risk may be mitigated by employing various options strategies in a way that will secure your capital from major losses. A Protective Put Option is one such Options trading strategy.

Protective Put Options Strategy

Protective Put is an options trading strategy designed to limit losses in an adverse situation. It includes holding a long position and simultaneously purchasing a Put Option at a strike price same as or close to the market price of the underlying.

Thus, a Protective Put Option strategy protects the investor in the case of a price correction. The purpose of this strategy is to hedge the risk involved with an unexpected fall in prices.

Consider the following protective put strategy example – Suppose, the current market price of Reliance Industries shares is Rs. 800. A trader believes that the price is undervalued and purchases 100 shares of Reliance Industries at Rs. 800. While the trader expects prices to rise, he wished to protect himself from the inherent risk involved.

As a result, the trader purchases an at-the-money Put Option to manage the risk associated with the naked position. He will purchase a Put option of Reliance Industries at Rs. 800 for a premium of Rs. 100. The lot size is 100 shares.

Prima facie, the cost involved is primarily on account of the premium paid for the Put option which is Rs. 1000. The gain or loss from the strategy will depend upon the price movement of the underlying asset.

Scenario 1 – The price of Reliance Industries increases to Rs. 850.

In this case, the price movement is following the trader’s expectation. Thus, the profit earned from the long position is Rs. 50 (Rs. 850-800) per share. However, the put option will expire worthlessly and the premium paid is a loss for the trader.

Thus, the overall profit from the trade is the difference between the profit from the trade and the premium paid calculated as Rs. 5,000 (Rs. 50 per share for 100 shares) reduced by a premium payment of Rs. 1,000. The net gain from the position is Rs.4,000.

If the investor had not purchased the put option, then the gain from the trade would be Rs. 5,000.

Scenario 2 – The price of Reliance Industries is unchanged at Rs. 800

Thus, the profit earned from the long position is Rs. 0 (Rs. 800 - 800) per share. The Put option will expire worthlessly and the premium paid is a loss for the trader.

Thus, the overall loss from the trade premium paid Rs. 1,000.

If the investor executed a naked put option (instead of a protective put), the investor would neither earn profit nor incur loss from the position.

Scenario 3 – The price of Reliance Industries increases to Rs. 750

In this case, the price movement is contrary to the investor’s expectation. Thus, the loss incurred from the long position is Rs. 100 (Rs. 800 – Rs. 750) per share. On the other hand, the gain from the Put option is Rs. 50 (Rs. 800 – Rs. 750) per share.

Overall, the net loss from the position is the premium paid of Rs. 4,000.

If the investor executed a naked put option (instead of a protective put), the loss from the trade would be Rs. 5,000.

The execution of a protective put option reduces the risk associated with a naked put trade, as intended.

When should you use a Protective Put Strategy?

The protective put strategy is quite similar to that of insurance. The primary objective is to limit the losses which may arise due to an unexpected fall in prices of the underlying. While a trader may adopt a bullish approach in the long term, the risk from unexpected price movements in the short term may be mitigated using a protective put.

The gain or loss from the strategy is a factor of the price movement of the underlying. However, the premium paid for purchasing the option is added to the total cost of a protective put.

Risks and Rewards associated with Protective Put Strategy?

  1. The risk to reward ratio for a protective put is favorable. The profit potential offered by a protective put is unlimited whereas the risk involved is limited. Profit from the trade may be attributable to the difference between the sale price and the strike price of the underlying reduced by the premium paid. You earn a profit when the price of the underlying is more than the sale price of the underlying.

  2. The maximum loss from a protective put is limited to the premium paid for purchasing the Put option. A trader incurs a loss when the price movement is not in line with the trader’s expectation at the time of entering the trade. If the price of the underlying is more than the strike price of the put option then the trade results in a loss.

In this way, a Protective Put Options strategy can be a safety net in case the path of the trade moves sideways. While the losses are minimal, the profits earned are worthwhile. However, such strategies work best only when thoroughly researched or consulted with an expert like those at IIFL.

Frequently Asked Questions Expand All

A protective put is an ideal strategy in cases where a trader wants to hedge the risk involved with a fall in price. However, if the trader is confident about his bullish approach and does not expect a price correction then a naked long position may prove to be more beneficial. The trader can eliminate the cost involved in a protective put.