How would you like to protect yourself against a possible downturn in a stock that you own? If so, then you should consider a protective put.

In a nutshell, a protective put is an insurance policy. It gives you the opportunity for unlimited gain while limiting your loss.

The only downside to a protective put is that you’ll have to spend money when you purchase it.

But if you think about it, that’s exactly how an insurance policy works: you fork over some cash to limit your risk. A protective put is no different.

In this article, I’ll explain a protective put in detail so that you can make an informed decision about whether or not it’s an investment strategy you should pursue.

What is a protective put?

A protective put (sometimes called a “married put”) is an investment strategy that involves the use of a stock option.

If you’re unfamiliar with stock options, they give you the right, but not the obligation, to buy or sell a stock at a specific price at some point in the future.

You would do that to “lock in” the price by an upcoming date. That way, you can make money if the price moves in the right direction.

There are two kinds of stock options: calls and puts.

A call option is an option to buy a stock at a specific price in the future. You would do that if you think the stock price is going up.

A put option is an option to sell a stock you own at a specific price in the future. You would do that if you think the price is going down.

You can also buy put options on the open market if you think a stock is going to lose value in the short term. That way, when the stock price drops your put option increases in value.

In a protective put strategy, you buy put options against shares of stock that you own. That way, if those shares drop in value, the value of your put option increases. That’s how your losses are limited.

When would you use a protective put?

A good time to use a protective put is when you own a stock that’s a great long-term investment but there’s a sudden market downturn. In that case, you’d buy the protective put to limit your losses in the event that things get really ugly.

You could also buy a protective put to “lock in” your profits. If you’ve made a bunch of money on a stock, and you still think it has room to grow, you could buy a protective put so that you still profit even if the price drops dramatically.

How does a protective put work?

A protective put strategy works like this: you buy a stock and also buy a corresponding put option for that stock.

For example, let’s say you buy 100 shares of Tesla at $280 per share. If you’re practicing the protective put strategy, you’d also buy a single put contract for Tesla.

Why a single contract? Because a single options contract represents 100 shares of stock.

If the Tesla stock price goes up, you’ll lose the money you invested in the put option. However, you’ll likely still make an overall profit because the stock price increased.

On the other hand, if Tesla drops like a rock, you’re protected by the put option. That’s because put options increase in value as the underlying stock price goes down.

Protective puts are a great investment strategy because they give you the opportunity for unlimited gain while limiting your loss.

Real life example using a protective put?

Suppose you own 100 shares of Tesla. You paid $280 per share for the stock and it’s trading at $340 per share right now.

But you think it might go down because of some recent bad press. So you buy a put option to hedge yourself.

Remember: a single option is a contract that represents 100 shares.

You do some research on your favorite trading platform and see that you can buy a put option for $6.05 with a strike price of $300.

Let’s unpack what all that means.

First of all, a put option that costs $6.05 really costs $605. That’s because the price is on a per-share basis. Recall that one contract represents a hundred shares so $6.05×100 = $605.

For the purposes of a protective put, the strike price is your “firewall.” That’s the point where your losses stop.

If you buy a put option with a $300 strike price, then your losses are limited to the same amount that you would lose if you sold Tesla at $300 per share. That’s the case no matter how low the price drops.

Even if Tesla dropped all the way down to $20 per share, your losses would be limited to what you’d lose if you sold it at $300 per share.

Why? Because put options increase in value as the underlying stock price decreases in value.

What happens if Tesla goes up in value? You’d lose the $605 that you paid for the put option.

Keep in mind, though, you’d still make a profit.

If Tesla goes up to $380 in value and you own 100 shares, then your position is worth $3,800. You bought the stock at $280 per share so you paid $2,800 for 100 shares.

Let’s say you sell your position at $3,800. You earn $1,000 ($3,800 – $2,800) in capital gains minus the amount of money you paid for the put ($605). Instead of $1,000, your profit is $1,000 – $605 or $395.

Read Also: What Are The Best Dividend Stocks

What are similar strategies relation to protective put?

In addition to a protective put, there are other options strategies that offer the potential for unlimited gain with limited loss.

One of those is a long call. That’s when you buy a call option on the open market.

Why would you want to do that instead of buying the stock? Because you can earn a much better return.

Let’s say you buy 100 shares of Kohl’s at $80 per share. Within a month, the price goes up to $90 per share. You just made $1,000 or 12.5% profit.

On the other hand, let’s say you decide to buy $80 call options instead of the stock. Those options cost you $1.25 per contract or $125 total. If the underlying price soars to $90, then the value of your option will go up $10 per contract. You could sell your call option for $11.25, pocketing $1,000 profit.

But here’s the difference: with the call options you only invested $125 instead of $8,000. So your return is a whopping 800%! That’s why options are so attractive.

Another similar strategy to a protective put is a call backspread. That strategy involves selling call options on stocks you own while buying more options at a higher strike price.

Protective put compared to other options strategies?

A protective put is attractive because you don’t need to be an advanced options strategist to understand it. As you can see from the description the call backspread just above, some options strategies can be very complicated.

Even if you’re a complete newbie to options, you can understand the concept of buying “insurance” and limiting your loss.

It’s also superior to a long call because you don’t need to play guessing games about when a stock price will go up. When you buy a long call, the stock price has to increase during the contract period or you don’t earn a profit.

Also, you get dividends when you own a stock. A long call won’t give you any dividends.

Advantages & Risks of protective puts?

As with any other investment strategy, there are a variety of advantages and risks associated with protective puts.

Protective Put Advantages

• Unlimited gain – Some options strategies (like the covered call) limit your gain. That’s not the case with protective puts. The sky’s the limit when it comes to profit.
• Limited risk – You limit your loss with a protective put. That’s because the maximum you can lose is the amount of money you paid for the stock minus the strike price of the put option.

Protective Put Risks

• Costly over time – Put options aren’t free. You have to pay for them. They also come with an expiration date. So if you keep buying them over and over again, you’ll eat into the profit you earn as your stock goes up in value.
• You could still lose – Even though you can limit your loss with a protective put, that doesn’t mean you won’t lose anything. If your stock price drops, you could still take a loss. You’ll also lose the amount of money you invested in the protective put.