Understanding Protective Put

3.4

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In the previous chapter, we discussed the bear call ladder options strategy and saw how you can use it to set up a profitable trade. We’re going to be taking a similar route in this chapter as well. The options strategy that we’re about to dissect in the forthcoming segment is known as the ‘Protective Put.’ So, let’s get going.

What is the protective put?

Also known as the married put, the protective put is an options trading strategy that’s generally used by traders to hedge their risk. It is extremely simple to understand - and simpler to execute. The strategy is primarily used by traders who have a bullish outlook on the market, but are still wary of the market moving against their expectation. Therefore, to minimize losses, traders typically use the protective put trading strategy to hedge the investment risk.

How to set up a protective put?

Let’s take a quick look at the steps that you would need to follow to get this strategy going.

  • One of the prerequisites for setting up a protective put is that you need to first own the shares of a company. 
  • And not just any company, but one that also has an active derivatives segment. Otherwise, it is simply not possible to execute the strategy.
  • Once you’ve bought the shares of a company, you would then need to purchase a put options contract of the stock. 
  • Make sure that the lot size of the put options contract matches the total number of shares that you own.

And that’s it! With the purchase of the put options contract, you’ve successfully set up a protective put trading strategy.

How does the protective put work?

Now that you know how to set up a trade using the protective put trading strategy, here’s a brief overview of how it actually works.

Let’s take up an example to better understand this concept. Here are a few of the assumptions that we’re going to make.

  • You have a bullish outlook on the market.
  • With that view in mind, you’ve bought 1,000 shares of Adani Enterprises Limited at Rs. 1,245 per share. 
  • The total capital outlay comes up to Rs. 12,45,000 (Rs. 1,245 x 1,000). 
  • Despite having a bullish outlook, you would also like to protect yourself from any potential downsides that the market may have in store for you. 
  • And so, you’ve decided to safeguard your investment using the protective put options trading strategy
  • You intend to purchase the ADANIENT MAY 1240 PE since the strike price of Rs. 1,240 is the closest to the purchase price of the stock (which is Rs. 1,245).  
  • The lot size of the options contract of this stock is set at 1,000.
  • The premium that you would have to pay for Adani Enterprises Limited’s put options contract is currently at Rs. 20 per share. 
  • Therefore, the total premium that you would have to pay for purchasing one lot of put options contracts of the stock comes up to Rs. 20,000 (Rs. 20 x 1,000).  
  • The expiry date of the put options contract that we’re going to consider would be May, 2021.

Now that we’ve set the stage for the protective put trading strategy, let’s take up three different scenarios and see what would happen.

Scenario 1: The share price falls down to Rs. 1,230

When the share price of Adani Enterprises Limited falls to Rs. 1,230, here’s what would happen.

  • Since you already hold the shares of Adani Enterprises Limited, you would make a loss of Rs. 15 per share (Rs. 1,245 - Rs. 1,230), which comes up to Rs. 15,000 (Rs. 15 x 1,000).  
  • However, seeing as you hold a put option, the premium for the contract would end up increasing up to say Rs. 35 per share. 
  • This would give you a profit of Rs. 15 per share (Rs. 35 - Rs. 20), which comes up to Rs. 15,000 (Rs. 15 x 1,000). 
  • Since the profit from the put options contract has set off the loss on your investment, you’ve basically created a no-profit, no-loss scenario using the strategy.

Scenario 2: The share price rises up to Rs. 1,265 

Alternatively, let’s take a look at what would happen if the share price rises up to Rs. 1,265, in line with your expectations.

  • You would be making a profit on your investment in Adani Enterprises Limited to the tune of Rs. 20 per share (Rs. 1,265 - Rs. 1,245), which comes up to Rs. 20,000 (Rs. 20 x 1,000).  
  • At the same time, your put option would start to lose money. Let’s say that the premium for the contract goes down to Rs. 10 per share. 
  • This would give you a loss of Rs. 10 per share (Rs. 20 - Rs. 10), which comes up to Rs. 10,000 (Rs. 10 x 1,000). 
  • At the end of it all, you would be leaving with a net profit of Rs. 10,000 (Rs. 20,000 - Rs. 10,000) as a result of this trade.

Scenario 3: The share price stays at Rs. 1,245 

If the share price stays the same at Rs. 1,245, here’s what’s likely to happen.

  • Your stock investment would lead to a no-profit, no-loss scenario.
  • However, your put option would start to lose money. 
  • The premium for the put option contract would likely decrease slowly due to the time decay factor. 
  • Let’s assume that the premium drops down to Rs. 17 per share, you would end up with a nominal loss of Rs. 3,000 [(Rs. 20 - Rs. 17) x 1,000].

Though you end up with a nominal loss under this scenario, the protective put options strategy ultimately only helps minimize and restrict your downside.

Wrapping up

As you can see from the above scenarios, a carefully placed protective put options trading strategy gives you a strong protection from losses due to unfavourable market movements. Since this strategy can limit losses to a large extent, it is quite popular with traders.

A quick recap

  • The protective put is also referred to as the married put.
  • It is an options strategy that’s used by traders to hedge their risk.
  • The strategy is primarily used by traders who have a bullish outlook on the market, but are still wary of the market moving against their expectation. So, to minimize losses, traders typically use the protective put to hedge the investment risk. 
  • One of the prerequisites for setting up a protective put is that you need to first own the shares of the company whose derivatives you intend to use. 
  • Once you’ve bought the shares of the company, you need to purchase a put options contract of the stock. 
  • Make sure that the lot size of the put options contract matches the total number of shares that you own.
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