Protective Put Option – Option Trading

A put option purchased for an underlying security that is already owned by the holder of the option. A protective put defends against a drop in the share price of the underlying security.
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.

The formula for calculating profit is given below:

1. Maximum Profit = Unlimited
2. Profit Achieved When Price of Underlying > Purchase Price of Underlying + Premium Paid
3. Profit = Price of Underlying – Purchase Price of Underlying – Premium Paid

When to use
When you are long stock and want to protect yourself against a market correction.

A Protective Put strategy has a very similar pay off profile to the Long Call. You maximum loss is limited to the premium paid for the option and you have an unlimited profit potential.

Protective Puts are ideal for investors whom are very risk averse, i.e. they hold stock and are concerned about a stock market correction. So, if the market does sell off rapidly, the value of the put options that the trader holds will increase while the value of the stock will decrease. If the combined position is hedged then the profits of the put options will offset the losses of the stock and all the investor will loose will be the premium paid.