Protective Put Strategy

In the previous chapter we explored the Covered Call Strategy to derive extra income from your stock portfolio. Volatility is inevitable in the market. Protection of investments is key to your long-term success. Now, one of the strategies that assure you downside protection while you continue being invested in your stock is the Protective Put Strategy. Let's take a closer look at how this works and when to do it.

What is a Protective Put?

A Protective Put is an options strategy whereby you buy a put option on the stock you own. The put option gives you the right but not the obligation to sell your stock at a predefined price called the strike price before the option expires. It helps in limiting the potential loss if the stock price severely falls, acting like an insurance for your investment.

How does a protective put work?

Suppose you have a stock in the HDFC Bank currently trading at ₹1,500 but are concerned about short-term losses in its price. You may purchase a put option with a strike price of ₹1,400 at a premium of ₹50 per share.

• In case HDFC Bank falls to ₹ 1,300, you can exercise the put and sell your shares at ₹ 1,400, hence limiting your loss to ₹ 50 a share-the premium paid.
  
• If the stock remains above ₹ 1,400, you will not exercise the option, and your loss is limited to the premium of ₹ 50 per share.
  
• This is how the protective put helps you limit losses while still keeping the upside potential for gains if the stock price goes up.
  

Why use a Protective Put?

The Protective Put strategy is most effective when one wants to hedge against downside risk without selling his stock. Here's why it's popular:

1. Downside protection: This protective put allows you to sell your shares at a predetermined price in case the stock drops significantly.

2. Peace of Mind: Since you are holding on to the stocks but are concerned about the short-term volatility, this strategy gives you protection against sharp downside movements, thereby giving you security to stay invested without tension.

3. Flexibility: One can still hold his stock with protection on and enjoy the upside should it happen that the price increases.

Risks of the Protective Put Strategy

While the protective put offers protection, there is some downside:

1. Cost of the Put Option: The major risk is the premium you pay for the put. If the stock does not decline, the paid premium turns into a sunk cost and lowers your total return.

2. Limited Profit: Although the protective put offers upside potential, the profit is reduced by the premium paid for the option. You benefit from price increases, but the gains are not as big as they would be if there were no cost to the option.

3. Expiration Risk: You lose the premium if the stock does not decline before the option expires. Hence, timing of buying the protective put is crucial.

When to use a protective put?

The protective put strategy is best deployed under the following conditions:

Short-term volatility: You might expect market corrections or declines in a stock's price within the near term. In this regard, a protective put shields your investment.

Long-term holding: You believe in the long-term growth of the stock but are concerned with short-term fluctuations. So this strategy covers you while holding onto the shares.

Risk-averse investors: The protective put acts like a cushion to your portfolio in case huge losses arise when market volatility strikes.

Conclusion

The Protective Put Strategy is another intelligent way of securing your investments against sharp declines yet maintaining the potential for upside. Particularly useful in cases where largecap stocks, such as Reliance, Infosys, or HDFC, are held by Indian investors who want to safeguard their portfolios in times of volatility.

You have to consider that the put option itself comes at a cost in applying this strategy. The protective put gives comfort and protection from downside events, but of course like any form of insurance, it doesn't come for free. If done right, it can be a key part of the risk management strategy in your investments.

Having understood the strategy of the Protective Put Strategy for protection of your investments, let's head to another exciting strategy, the Long Straddle. It is the perfect strategy for traders who expect high volatility but are not sure about the direction in which the price will move. Next, we will break down how the Long Straddle works and when it can be a game changer in your options trading strategy.