Posted On March 14, 2020
A protective put strategy is a strategy that mitigates portfolio risk for investor that has positions in underlying instruments within the financial markets. This strategy is employed by institutional investors as well as novice traders. A protective put strategy is different from a put buying strategy in that the investor in a protective put strategy is looking to protect gains in an underlying instrument, where in a put buying strategy, the investor is looking to short (sell) a particular market.
What is a put option?
A put option gives the buyer the right, but not the obligation, to short (sell) the underlying instrument at a pre-established price (the strike price) on or before a fixed date (option expiration date). For example, if you purchase a WTI Crude Oil $60 put option, you have the right, but not the obligation, to short (sell) WTI crude at $60 per barrel (strike price) on or before the expiration date. The amount an investor pays for an option is called the premium. If you are a purchaser of a protective put, your risk on the put is limited to the premium you paid for the put option.
In a protective put strategy, the investor is the option buyer, and therefore the risk on the protective put is limited to the premium used to purchase the options. Investors will need to determine how close they would like the strike of the protective put to be relative to the current market. Why is this important? The closer the strike is to the current market, the more protection an investor purchases. For example, if an investor purchases a $60 WTI crude oil put when the market is at $100, the investor will not own protection on the underlying WTI crude from $100 to $60. If the investor paid more premium and purchases a $100 put of WTI crude oil, the investor would own protection for the entire market move if WTI crude oil moved from $100 to $90.
When using the protective put strategy, the investor will have a different risk when comparing this strategy to owning puts without owning the underlying instrument. The protective put strategy is employed to mitigate risk, and the premium is used as insurance against a downward move in the underlying market. The investor understands that he will lose his premium if the option is held to maturity, but is willing to give up this premium to protect against a downward move. As the market moves lower, the value of the protective put will move higher.
The main reason to use a protective put strategy is to mitigate the risk of owning an underlying instrument or portfolio. This strategy is sometime combined with other protective strategies like covered call writing. The goal of these strategy is not directional risk, and an investor should understand the risks involved in naked call and put strategies and how they different from protective portfolio strategies.