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There are typically two different reasons why an investor might choose the protective put strategy;. A protective put position is created by buying or owning stock and buying put options on a share-for-share basis.
In the example, shares are purchased or owned and one put is purchased. If the stock price declines, the purchased put provides protection below the strike price. The protection, however, lasts only until the expiration date. If the stock price rises, the investor participates fully, less the cost of the put. Potential profit is unlimited, because the underlying stock price can rise indefinitely. However, the profit is reduced by the cost of the put plus commissions.
Risk is limited to an amount equal to stock price minus strike price plus put price plus commissions. In the example above, the put price is 3.
The maximum risk, therefore, is 3. This maximum risk is realized if the stock price is at or below the strike price of the put at expiration. If such a stock price decline occurs, then the put can be exercised or sold. See the Strategy Discussion below. The protective put strategy requires a 2-part forecast.
First, the forecast must be bullish, which is the reason for buying or holding the stock. Second, there must also be a reason for the desire to limit risk. Perhaps there is a pending earnings report that could send the stock price sharply in either direction. In this case, buying a put to protect a stock position allows the investor to benefit if the report is positive, and it limits the risk of a negative report.
Alternatively, an investor could believe that a downward trending stock is about to reverse upward. In this case, buying a put when acquiring shares limits risk if the predicted change in trend does not occur. Buying a put to limit the risk of stock ownership has two advantages and one disadvantage.
The first advantage is that risk is limited during the life of the put. Second, buying a put to limit risk is different than using a stop-loss order on the stock. Whereas a stop-loss order is price sensitive and can be triggered by a sharp fluctuation in the stock price, a long put is limited by time, not stock price.
The disadvantage of buying a put is that the total cost of the stock is increased by the cost of the put. If the stock price is below the strike price at expiration, then a decision has to be made whether to a sell the put and keep the stock position unprotected, b sell the put and buy another put, thus extending the protection, or c exercise the put and sell the stock and invest the funds elsewhere. The total value of a protective put position stock price plus put price rises when the price of the underlying stock rises and falls when the stock price falls.
The value of a long put changes opposite to changes in the stock price. When the stock price rises, the long put decreases in price and incurs a loss. And, when the stock price declines, the long put increases in price and earns a profit.
Put prices generally do not change dollar-for-dollar with changes in the price of the underlying stock. In a protective put position, the negative delta of the long put reduces the sensitivity of the total position to changes in stock price, but the net delta is always positive. Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant.
A long put, therefore, benefits from rising volatility and is hurt by decreasing volatility. As a result, the total value of a protective put position will increase when volatility rises and decrease when volatility falls. This is known as time erosion. Since long puts decrease in value and incur losses when time passes and other factors remain constant, the total value of a protective put position decreases as time passes and other factors remain constant.
Stock options in the United States can be exercised on any business day, and the holder long position of a stock option position controls when the option will be exercised. Since a protective put position involves a long, or owned, put, there is no risk of early assignment. If a put is exercised, then stock is sold at the strike price of the put.
In the case of a protective put, exercise means that the owned stock is sold and replaced with cash. Therefore, if an investor with a protective put position does not want to sell the stock when the put is in the money, the long put must be sold prior to expiration. There are important tax considerations in a protective put strategy, because the timing of protective put can affect the holding period of the stock.
As a result, the tax rate on the profit or loss from the stock can be affected. Investors should seek professional tax advice when calculating taxes on options transactions. If a stock is held for more than one year before it is sold, then long-term rates apply, regardless of whether the put was sold at a profit or loss or expired worthless.
If a stock is owned for less than one year when a protective put is purchased, then the holding period of the stock starts over for tax purposes. However, if a stock is owned for more than one year when a protective put is purchased, then the gain or loss on the stock is considered long-term regardless of whether the put is exercised, sold at a profit or loss or expires worthless.
Long put - speculative. In return for paying a premium, the buyer of a put gets the right not the obligation to sell the underlying instrument at the strike price at any time until the expiration date. A collar position is created by buying or owning stock and by simultaneously buying protective puts and selling covered calls on a share-for-share basis. Reprinted with permission from CBOE. The statements and opinions expressed in this article are those of the author.
Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data. Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options.
Supporting documentation for any claims, if applicable, will be furnished upon request. Charts, screenshots, company stock symbols and examples contained in this module are for illustrative purposes only. Skip to Main Content. Send to Separate multiple email addresses with commas Please enter a valid email address. Your email address Please enter a valid email address. Potential Goals There are typically two different reasons why an investor might choose the protective put strategy; To limit risk when first acquiring shares of stock.
Long shares at Related Strategies Long put - speculative In return for paying a premium, the buyer of a put gets the right not the obligation to sell the underlying instrument at the strike price at any time until the expiration date.
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