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Options Strategies: Protective Put

Option Strategies

Summary:  Protecting your shares against a decline - By buying a put option you can protect your shares against a decline with a limited investment. And you can decide for yourself how long the insurance should run.


Stocks and a bought put

A purchased put option gives the right to sell an underlying asset (a share, for example) for a certain amount. It can be seen as a kind of insurance on a stock hat you own.

You are probably familiar with the fire insurance policy - should your house catch on fire - you get the money back with which you can buy a new house. Put options are very similar. As with fire insurance, you will have to pay money for the right to sell your shares for a certain amount during a certain period of time.

Why would you want to do this?

Suppose you expect a certain stock in your portfolio to fall. You can now sell the share, but you can also buy an option that gives you the right to sell the share for a certain amount. You thus insure a minimum value of this share. An option contract is valid for 100 shares, so prices will always have to be multiplied by 100.

Example

Let's take a look at an imaginary ABC stock. The share is currently trading at $25.33 and you would like to be able to sleep peacefully. You are thinking about buying a put to make sure you can always sell the stock for a certain amount.

The share is now slightly above €25 and you want to buy the right to be able to sell the share for $22 for two years. This means that you have built in a small piece of deductible, but that makes the put (the right to sell) a lot cheaper. For the put ABC 22 put that runs for (almost) 2 years, you have to pay $1.70.

What does this mean?

If you were to buy this put, you have the right – and not the obligation – to sell the ABC share at $22. This right runs for two years.

When are you happy with this right?

The question here is really: are you happy when the fire insurance is paid out? Probably the answer is no. Ideally, you want the share to rise, because it is an insurance policy that you have bought. But you will probably be happy if the share falls to $10 as a result of, for example, a bad profit development. You can then still sell at $22 because that is the insurance that you have taken out.

The put gives the right to sell the share for $22 while it trades on the stock exchange for $10. This means that the sales right on $22 must be worth at least $12! Then the put that you bought for $1.70 would have become worth at least $12! This does not mean that you are making a profit because you are still losing more money on the shares you own. But a large part of the decrease is compensated by the sales right on $22 in your possession.

When are you not happy?

If the share drops to exactly $22 on the expiry date of your option. You then make a loss on your shares and the put has become worthless.

When do you buy a put?

There are two reasons to buy a put. The first is if you want insurance on the stock you own. This is a defensive trade and has been explained above. The other reason is an expected fall in an underlying asset that you do not own. This is an offensive trade.

When do you sell the purchased put?

Once you've bought a put, you don't have to stay in it until the end of the term. You can also sell this put at any time during the trading day. So you could buy a put on Wednesday and sell it again on Friday.

In principle, if you bought the option as insurance, you do not sell it because if you did, you would lose the insurance. What you could do is exchange (roll-over) the put at some point to a put with a longer term to maintain the insurance.

What is your maximum risk?

If you bought the stock and want to insure it with a put, the maximum loss is the difference between the purchase price of the stock and the level of insurance (the strike price) plus the premium paid for the insurance. In the ABC example, that is $25.33 minus € 22,- plus $1.70. In total, your maximum risk on this position is therefore $5.03.

In short

You buy a put as protection if you own the underlying asset. You will still lose money if the share should unexpectedly fall, but that loss is a lot less that it would be without the option acting as insurance


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