As an investor, there are few things worse than seeing an
otherwise fundamentally sound stock drop precipitously on the back
of news that is totally unexpected or only tangentially related to
the given company -- such as the European debt crisis. However,
there is some reprieve for investors from this frustration; by
a protective put
, you can obviate large downside risk of black swan events.
[caption id="attachment_70103" align="alignright" width="300"
caption="No need to panic. Protective puts are a great way to lock
in profits in uncertain times"]
Unexpected news that adversely affects a stock occur all the
time. Given the fragile state of the European economy, it's now
become a regular occurrence for healthy stocks to drop 10-15% over
the span of a few months, even if the fundamental growth story
behind a given stock hasn't changed.
However, by employing a protective put strategy, you can
substantially reduce the downside risk in a long position.
A protective put is, usually, an out-of-the-money option
designed to increase in value as a stock declines. Let's look at an
example. Let's say you own 100 shares of stock XYZ that is now
worth $100 and you purchased this position at $80. By buying a 95
put for, say, 1.00, you've now locked in profits at $94 because the
put gives you the right to sell this lot of 100 shares for $95, no
matter what the price of the underlying asset is. Until the
expiration of this option, downside risk in this position has been
Ideally, investors would like to purchase a protective put when
the market is performing well. At times like this, there is usually
very little fear in the market, which allows you to purchase puts
with a lower
Evidently, this is a position in which you would ideally not
like to make money on the put itself. The point of using a
protective put is to decrease potential losses, not to make money
from the option.
If you're under the impression that a given stock is going to
head significantly lower,
there are better strategies
to take full advantage of such a move downwards. The protective
put, rather, is designed to allow investors to maintain long
positions while shielding you from a move to the downside.