Protective Put Option Strategy
A protective put option strategy is being long a put option while also being long the underlying stock. Investors with an investment objective of capital preservation utilize the protective put option strategy. The long put option gives the investor the right to sell the stock at the strike price within a specified time-period if the stock declines. For this, the investor pays a premium for the put option which gives the right to sell 100 shares of stock.
The maximum upside potential for a protective put option strategy is theoretically infinite as the stock price can potentially rise to any price.
The maximum potential loss is the amount paid for the long put premium, plus the difference between the price paid for the stock and the strike price of the long option. Therefore, a protective put option strategy requires a considerable level of risk tolerance. The breakeven point of a put option is the price paid for the stock plus the premium for the long put option. An investor who has a bearish outlook that anticipates the stock price to decline beyond a certain price by a set-date utilizes a protective put option strategy.
Let’s See an Example:
An investor anticipates that the stock price of EIO will decline in the next 3 months. The investor bought EIO at $11 a month ago, while EIO currently trades at $10. He purchases a put with 3 months until expiration with a $10 strike price that trades at $2.
The investor buys 100 shares of EIO at $11, and later buys a put option at the $10 strike price with 3 months until expiration date for a premium of $2.
The maximum potential profit is theoretically infinite since the stock can rise to any price. This is calculated as follows:
Maximum Profit = (Infinite Stock Price - Premium) x 100 shares
$∞ = ($∞- $2) x 100 shares
The maximum potential loss is the premium of $2 paid for the put option plus the $1 difference between the stock purchase price and the strike price multiplied by 100 shares. This is calculated as follow:
Maximum Loss = (Premium Paid + Price Paid for Stock – Strike Price of Put) x 100 shares
$300 = ($2+$11 - $10) x 100 shares
The breakeven point is $13, which is the purchase price of the stock at $11 plus the $2 premium paid for the put option.
Break Even Point = Strike Price - Premium Paid
$13 = $11 + $2
The profit and loss of the protective put option strategy until expiration date is depicted in the chart below.
The chart shows the potential profit and loss on the y-axis versus the corresponding stock price in the x-axis until the expiration date.
If EIO trades remain above $13 and beyond, the protective put strategy will be profitable. If EIO remains below $13, the most the investor can lose is $300 until the expiration date. The breakeven point is $13, which is the $11 price paid for the stock plus the $2 premium.
If the stock price of EIO falls anywhere between $10 and $0 during the duration of the option contract, the long put holder can exercise the option. This results in the investor selling 100 shares of EIO at $10. The put option acts as insurance from losing any more than $300 from the investment in EIO. If price of EIO falls to $0, the investor is still able to sell the EIO for $10 a share. If the investor, however, did not want to sell the position in EIO, he could instead sell the put option at a profit.
However, if the stock price of EIO remains between $10 and $13 during the life of the option contract, the investor loses anywhere between $0 and $300.
