The protective put, or put hedge, is a hedging strategy where the holder of a security buys a put to guard against a drop in the stock price of that security.
Long 100 Underlying, Buy 1 ATM Put
A protective put strategy is usually employed when the options trader is still bullish on a stock he already owns but wary of uncertainties in the near term. It is used as a means to protect unrealized gains on shares from a previous purchase.
Unlimited Profit Potential
There is no limit to the maximum profit attainable using this strategy. The protective put is also known as a synthetic long call as its risk/reward profile is the same that of a long call's.
Unlimited
Profit achieved when: Price of Underlying > Purchase Price of Underlying + Premium Paid
Profit = Price of Underlying - Purchase Price of Underlying - Premium Paid
Limited Risk
Maximum loss for this strategy is limited and is equal to the premium paid for buying the put option.
Premium Paid + Purchase Price of Underlying - Put Strike + Commissions Paid
Loss occurs when: Price of Underlying <= Strike Price of Long Put
Breakeven point
Purchase Price of Underlying + Premium Paid
Example
An options trader owns 100 shares of XYZ stock trading at $50 in June. He implements a protective put strategy by purchasing a SEP 50 put option priced at $200 to insure his long stock position against a possible crash.
Max Loss Capped at $200
Maximum loss occurs when the stock price is $50 or lower at expiration. Even if the stock price nosedived to $30 on expiration, his max loss is capped at $200. Let's see how this works out.
At $30, his long stock position will suffer a loss of $2000. However, his SEP 50 put will have an intrinsic value of $2000 and can be sold for that amount. Including the initial $200 paid to buy the put option, his net loss will be $2000 - $2000 + $200 = $200.
Unlimited Profit Potential
There is no limit to the profits attainable should the stock price goes up. Suppose the stock price rallies to $70, his long stock position will gain $2000. Excluding the $200 paid for the protective put, his net profit is $1800.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.