How does a Protective PUT Option Work?
When you purchase a Put Option over shares you own, you are effectively ensuring your shares against loss because you have the right to sell your shares at an agreed price at any time throughout the life of the Put Options contract.
In much the same way as you would insure your house or car for a specific value, a Put Option has a ‘strike price’ which is the amount you have the right to sell your shares for.
Like a traditional insurance policy, the Protective Put has an expiry date, after which you need to renew your insurance policy. You may also select the time period over which you wish to insure your shares.
An example would be if you purchased some shares for say $ 20 and at the same time, you purchased a 12 month dated Put Option with a $ 20 strike price. You would have the right to sell your shares to the market at any time within the next year for $ 20, regardless of what price the shares were trading at.
When Would You Use a Protective Put?
You would employ a protective put when you own shares in the underlying stock and you have an unrealized profit from capital growth that you wish to protect without having to sell your shares, or you may have just purchased the shares and simply want peace of mind in case the share price were to fall.
Although you would be hedging against a downside move, your overall view on the underlying stock would be Bullish.
How Does a Protective Put Benefit You?
When you use Option Trading Strategies like the protective put, the benefits you receive from being a shareholder (dividends etc) remain the same until such times as you sell your shares.
The real benefit to you is that your potential downside loss is limited throughout the life of the Put Options contract, regardless of how far the share price may fall in value. You have complete control over your shares as YOU choose which price to insure them at as well as when to sell them if the share price fell.
What is Your Risk vs Reward?
PROFIT: Your maximum profit potential is unlimited depending on how high the share price rises.
LOSS: Your maximum loss is limited to the difference between the price you can sell your shares for (strike price) and the cost of your Put Option protection (Strike Price – Option Premium Paid)
If you never used your put protection (exercised your right) and it expired worthless, any gain in capital growth would offset the premium you paid to own the Put Option.
Your break-even point would occur when the share price increased by the amount which you paid for the protective put.
Do You Have to Sell Your Shares?
NO! When you own a Put Option, you are under no obligation to sell your shares, or ‘exercise’ your right. You control when and if you sell and you can do so at any time up until the expiry date of the Put Option.
If the share price rose and your Put Option expired worthless, you would keep your shares and may wish to consider renewing your ‘insurance’
If the share price rallied before option expiry and you decided to sell your shares at a profit, you may also sell your Put Option back to the market and recover some of what you paid for it.
Just like your house or car insurance, if you took out insurance for 12 months and you sold the house or car after just 6 months, the insurance company would refund a portion of what you had paid.