Protective put

A protective put involves the buying of a put option on an underlying asset that you already own. An example of this would be an investor who wants to hold on to his 'company A' shares but fears a price decrease. An obvious option is to sell, but the investor will then lose any chance of a potential capital gain. Furthermore, the sale itself triggers transaction costs, and may be disadvantageous in terms of tax payment.

Instead, the investor can choose to keep his shares and buys some put options. This way the price will not fall below a defined base. The options hedge against price falls, and the strategy is therefore known as protective put.

The price on the share is 215. An assurance against the price falling below 210 before expiry may be achieved by purchasing put options with a strike price of 210. The premium of the put option is 10 per share.

The option will compensate any loss resulting from a price falling below 210. If, on the other hand, the expiry price on the share is above 210, there is no payment on the assurance, and the investor’s loss or expense will equal the premium paid.

The graph below shows both the net price gain on the share in relation to the present price of 215 and the net gain on the put option. In respect of price falls below 210 the gain on the put option will offset the loss on the share.