Options traders use protective puts as a hedging strategy in case the market takes an unexpected plunge. The trader enters a put option, in which profit can be made on a down market, after taking a long position in a stock, fund, or index. It’s a useful method of protecting potential profits from an earlier purchase. Here are other facts to know about protective puts.
Risk and Reward
The protective put, also called a synthetic long call, allows for unlimited profit potential. The maximum loss is limited to essentially the premium paid for buying the put option. In other words, the purchase price of the underlying asset plus costs for the put generates the breakeven point. This strategy allows the trader to put caps on maximum loss. Trading strategies that are similar to protective puts include married puts, long calls, and call backspread.
Part of the expenses paid by traders is small commission fees charged by brokers. Even though these fees tend to range from $10 to $20, they can add up to large capital expenses for active traders, even those who pick more winning than losing trades. Options traders who want to make multiple trades per day should look for a broker that charges low commissions. OptionsHouse.com is an example of a brokerage with low fees.
How Protective Puts Limit Losses
When the trader purchases a put, he or she chooses a strike price equal or near the current price of the underlying asset. This hedge strategy is similar to buying insurance that may cover paying for a future disaster. A put will not be exercised in a scenario in which the underlying asset price moves upward. The option will be exercised, however, if the asset falls in value.
Stock traders who are new to options may still be confused about the different world of puts and calls. The key point to remember is that a protective put will cap losses similar to how a “stop-loss order” sets an exact exit price for a stock to prevent further losses. Protective puts usually reflect the reverse of long positions held in stocks. Once a stock price falls below its purchase price, the trader is at risk of loss, which can then be countered by a protective put.
About The Author
Jeff Bishop is a professional trader, entrepreneur, and educator that is most well-known for founding the popular trading programs, Raging Bull Trading and Weekly Money Multiplier. After completing his bachelor’s degree in finance and economics, Jeff Bishop began trading professionally, before launching Raging Bull in 2010. He continues to work as an educator for both Raging Bull Trading and Weekly Money Multiplier.