Know Your Options: Protective Puts

Increasingly more advisors and investors are discovering the benefits of options strategies in their portfolios. There is great value in understanding and utilizing options strategies with the range of benefits they can provide portfolios, including protective puts.

Options strategies can mitigate volatility, enhance income, and limit losses, depending on the options used and their deployment in portfolios. Covered call ETFs tend to garner the most attention and investor allocation, but protective put strategies also have their place and are a great way to protect against losses and uncertainty.

See also: “Know your Options: Covered Calls

What Is a Protective Put?

A protective put entails holding an underlying security while also buying a put option at a premium on the underlying assets. The holder of the put can sell the underlying security at a strike price on a specific date. They can exercise the put at any point up until expiration, and the protective put limits any losses below the strike price. Those that purchase the protective put carry no obligation to exercise it.

Protective puts protect against downturns and function more like an insurance policy for the underlying securities. They’re great for when market outlooks in the near term appear bearish. They also are good in uncertain or volatile markets since they mitigate losses beyond the strike price. Protective puts can provide a strong hedge against market-wide or asset-specific risk.

Unlike covered calls, protective puts do not limit any upside potential of the underlying securities. The buyer of the protective put is out the premium and therefore needs the underlying asset to cross above both the initial cost and the added cost of the premium to break even.

A graph illustrating a long stock's break even point and the adjusted break even point when a protective put is bought for the long position.

Image source: Option Alpha