Introduction

You have heard many mentions of “protective puts” and are curious if this strategy could benefit you. As you explore further, you learn that there two primary reasons that market participants choose this strategy:

(1) To limit risk when first acquiring shares of stock.

(2) To protect a previously-purchased stock when the short-term forecast is bearish but the long-term forecast is bullish.

Recall that long put options give the holder the right, but not obligation, to sell stock at the strike price at a future date in time.

Worth noting: “Protective puts” and “married puts” involve the same combination of long stock and long puts on a share-for-share basis, but the names imply a difference in timing of when the puts are purchased.

• A “married put” implies that stock and puts are purchased at the same time, and married puts do not affect the holding period of the stock. If a stock is held for more than one year before it is sold, then long-term rates may apply, regardless of whether the put was sold at a profit or loss or expired worthless.
• A “protective put” implies that stock was purchased previously and that puts are being purchased against an existing stock position. Protective puts can affect the holding period of the stock for tax purposes. If a stock is owned for less than one year when a protective put is purchased, then the holding period of the stock may start over for tax purposes. However, if a stock is owned for more than one year when a protective put is purchased, then the gain or loss on the stock may be considered long-term regardless of whether the put is exercised, sold at a profit or loss, or expires worthless.

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What is a Protective Put?

A protective put position is created by buying (or owning) stock and buying put options on a share-for-share basis.

• If the stock price declines, the purchased put provides protection below the strike price. The protection, however, lasts only until the expiration date.
• If the stock price rises, the investor participates fully, less the cost of the put.

The protective put strategy requires a two-part forecast:

(1) First, the forecast must be bullish, which is the reason for buying (or holding) the stock.

(2) Second, there must also be a reason for the desire to limit risk.

Perhaps there is a pending earnings report that could send the stock price sharply in either direction. In this case, buying a put to protect a stock position allows the investor to benefit if the report is positive, and it limits the risk of a negative report. Alternatively, an investor could believe that a downward-trending stock is about to reverse upward. In this case, buying a put when acquiring shares limits risk if the predicted change in trend does not occur.

Example

Assume XYZ is trading at $125

• Buy 1 XYZ 125 put for $1.15
• Buy 100 XYZ shares

Outcome 1: Profit

With a protective put position, you are committing to a bullish stock sentiment, believing that the stock will increase in value and rise in price. There is unlimited profit potential.

Recall the formulas for calculating the profit or loss on an individual put option:

If K – S > 0,

Long Put Profit = Strike Price - Current Stock Price – Net Premium Paid

Short Put Loss = – (Strike Price - Current Stock Price – Net Premium Received)

If K – S < 0,

Short Put Profit = Net Premium Received

Long Put Loss = Net Premium Paid

To calculate our profit on the position, we use the following formula:

Profit = Profit/Loss on the Stock Position + Profit/Loss on the Long Put

Profit = (Current Stock Price – Purchase Price of Stock) x Shares – (Net Premium Paid x Quantity of Contracts x Multiplier)

Max Profit is unlimited.

Example

Assume XYZ is trading at $125, and you establish a protective put position:

Buy 1 XYZ 125 put for $1.15

Buy 100 XYZ shares

A week later, stock XYZ is trading higher at $130.

Outcome 2: Loss

With a protective put position, you have paid money (net premium) to establish an options position that gives you access to the stock’s unlimited downside profit potential while limiting your downside losses. This means that your potential losses are known:

Max Loss = Stock Price – Strike Price – Net Premium Paid

Example

Assume XYZ is trading at $125, and you establish a protective put position:

Buy 1 XYZ 125 put for $1.15

Buy 100 XYZ shares

A week later, stock XYZ is trading lower at $113.

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

Our maximum loss is capped and known.

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Outcome 3: Breakeven

The breakeven price for a protective put strategy occurs when the stock is trading at a price equal to the strike price plus the net premium paid.

In our example, the breakeven stock price equals $126.15 ($125 + $1.15 = $126.15, not including fees and commissions).

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At-A-Glance

Strategy

• Protective Put

Alternative Name

• Married Put
• Hedged Put
• Puts and Stock

Pre-Requisite Strategy Knowledge

• Long Put
• Long Stock
• Synthetic Long Call

Legs of Trade

• 1 leg

Sentiment

• Bullish

Example

• Long 1 XYZ 125 put
• Long 100 XYZ

Rule to Remember

• Long stock and long put on same stock

Max Potential Profit (GAIN)

• Unlimited upside potential

Break-Even Point

• The breakeven point occurs when XYZ stock price is trading equal to the strike price plus the net premium paid.

Max Potential Risk (LOSS)

• Stock price – Strike price – Net premium paid

Ideal Outcome

• XYZ price rises significantly above the strike price of the put

Margin Requirement

• No

Early Assignment Risk

• Early assignment risk applies to short options positions only.
• Long options have no risk of early assignment.

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