What is a Protective Put?
A Protective Put strategy involves holding a long position in a stock and buying a put option on the same stock. This strategy provides downside protection while still allowing you to benefit from upside gains in the stock price.
One Put Option Contract typically covers 100 shares. In this example, we assume:
- You own 100 shares of stock.
- You buy one put option contract (which covers 100 shares).
- You pay a premium of $3 per share for buying the put option.
How Payoff Works:
Let’s say the initial stock price is $100 and the strike price of the put option is $95:
- If the stock price falls below $95, you can exercise the put option and sell the stock at $95, protecting yourself from further losses.
- If the stock price rises above $95, the put option expires, and you keep the stock gains minus the premium you paid for the put option.
Example Payoff Scenarios:
- Stock Price = $90: You exercise the put option and sell the stock at $95. Total payoff = -$800 (due to $500 loss on stock and $300 premium cost).
- Stock Price = $100: The put option expires worthless. Payoff = -$300 (premium loss).
- Stock Price = $110: The put option expires worthless. Payoff = -$300 (premium loss), though you still keep stock gains.