Quantcast

Hedging Bets With Protective Puts


Shutterstock photo

During times of market volatility, even the most bullish of traders may become nervous about a stock's health. What's more, earnings season can leave stocks vulnerable to major downside moves. A "vanilla" option trader may buy puts to bet bearishly during these periods. Long puts, however, can also be purchased as a sort of insurance policy for a stock in your portfolio. 

Typically, a trader will purchase a protective put when they are long-term bullish on a stock's prospects, but fear a short-term decline. Unlike a vanilla bearish trader, buyers of protective puts are not hoping for a dip in the stock, but want the coverage of a married put just in case. A protective put will essentially "lock in" a minimum sale price for the shares, should they go south.

For example, let's say a trader owns 100 shares of Stock XYZ, bought at $20 per share, for a total investment of $2,000. The stock then rallies to $30 a share, for a paper profit of $1,000. The trader believes the stock may appreciate further, but a particularly volatile market has him fearing short-term headwinds.

Instead of selling Stock XYZ, he buys one 22-strike put option for 50 cents, amounting to an upfront cost of $50 (since each option covers 100 shares). This way, he has the right to sell the shares for $22 each, if the stock falls beneath that level before the put's expiration. 

In an ideal scenario, the stock would ultimately rally higher, and the trader's portfolio gains would accrue. Here, he would be able to negate the $50 it cost for put protection and allow the option to expire worthless. 

But let's say the stock does wind up plummeting below the 22 strike before the option expires. In this case, the trader can exercise the protective put, selling his 100 shares at the $22 strike price -- or for $2,200 total. That's still a $200 profit from his initial investment. Had he sold his XYZ shares on the Street, he would've received less than that, and possibly could've taken a loss.

In conclusion, protective puts are much like any other insurance policy: buyers don't want catastrophe to strike, but if it does, the damage will be minimized. Further, speculators can customize their hedge in a number of different ways. Those willing to pay more for insurance can consider puts that are closer to the money, or options with a longer shelf life.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.



This article appears in: Investing , Options



More from Schaeffer's Research

Subscribe






Contributor:

Schaeffer's Research











Research Brokers before you trade

Want to trade FX?