Definition: The purchase of put options to fully protect shares.
When to Use?
The investor employing this strategy generally has unrealised profits on their shares and is concerned about risk in the near term. Purchasing puts while holding shares is a bullish strategy because ultimately the shareholder would like to see their shares go up even though this would mean the put option expires worthless. The put option acts as insurance or a stop loss order that can be executed at the discretion of the holder. The strategies is especially important for margin lending clients where an across the board fall in the market could trigger margin calls.
Like the married put investor, the protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the lifetime of the put contract, unless he sells his stock. At the same time, the protective put serves to limit downside loss in unrealised gains accrued since the underlying stock's purchase. No matter how much the underlying stock falls, the put guarantees the investor the right to sell his shares at the put's strike price over the life of the option.
Risk vs. Reward
Maximum Profit: Unlimited
Maximum Loss: Limited
Stock price - strike price + premium paid
Profit at Expiry: Gains in underlying share value since purchase - premium paid
Potential maximum profit for this strategy depends only on the potential price increase of the underlying security. If the put expires in-the-money, any gains realised from in an increase in its value will offset any decline in profits from the underlying shares. On the other hand, if the put expires at- or out-of-the-money the investor will lose the entire premium paid for the put.
Purchase price + premium paid
Passage of Time: Negative effect
The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration.
Alternatives before expiry
The investor employing the protective put is free to sell his stock and/or his long put at any time before it expires. For instance, if the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining.
Alternatives at expiry
If the put option expires with no value, no action need be taken; the investor will retain his shares. If the option closes in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put's strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on the option's last trading day. The premium received from the long option's sale will offset any financial loss from a decline in underlying share value.