The financial markets are a place where traders use different types of financial instruments in an attempt to generate profits. Many traders rely on option instruments to get a steady income from the financial markets. We will be talking about one such strategy here that is used by many traders and investors in the financial markets today. The protective put strategy is another advanced options trading strategy that can be implemented for hedging purposes. Similar to the covered call, protective puts are used to limit risk and gain potential profits in a declining market. This strategy involves purchasing shares of a company and buying protective put options on the stock simultaneously. It’s a very popular way to protect your portfolio from a bear market while still having the potential to profit from it if you’re right about its direction. The article details everything you need to know about the protective put strategy and how it can be used as part of your risk-management plan in your portfolio.

What is a Protective Put Strategy?

A protective put strategy is an advanced options strategy used to hedge a stock position against sharp price declines. Investors who want to hedge their portfolio against a sharp decline often use this strategy to limit their risk. A protective put strategy is an example of a “risk management” strategy, which means it’s used to reduce the amount of risk in your portfolio. When you use the protective put strategy, you own shares of the stock you’re trying to hedge and buy put options on that stock. Put options give you the right to sell that stock at the price you purchased it at any time over the next couple of months. If the stock price declines, you can exercise the put option and sell it at the price you bought it at. The put option protects your investment from a sharp decline because you can sell it at the price you purchased it even if the stock price goes down.

How Does the Protective Put Strategy Work?

The protective put strategy works by buying the stock you’re trying to hedge, and then you buy put options on that same stock. The put options are the protective part of this strategy because they allow you to sell that stock at the price you purchased it even if it declines. However, there’s an important difference between this strategy and the covered call strategy discussed above. In the covered call strategy, you’re selling your stock and then buying the right to buy it back again at a lower price. With the protective put strategy, you own the stock and buy the right to sell it even if the stock price declines. You can see how these are different. With the covered call strategy, you don’t own the stock and have to pay someone to buy it back. With the protective put strategy, you own the stock and have the right to sell it at the price you bought it at.

Advantages of the Protective Put Strategy

Several advantages are associated with the protective put strategy, making it an ideal hedging strategy for investors who want to limit their risk. As we discussed above, the main difference between the covered call strategy and the protective put strategy is that you own the stock with the protective put strategy. You have the right to sell it at the price you purchased. This means your risk is limited even if the stock price declines because you can still sell the stock at the price you bought it at and make a profit. The other big advantage of this strategy is that it gives you the potential to profit from a downward-trending market. If you’re right about the direction of the market and it declines, you can exercise the put option and then sell the stock at the price you bought it. This can result in a nice profit.

How to Implement the Protective Put Strategy?

The first thing that you need to do to implement the protective put strategy is to find a stock that you want to hedge. Ideally, you want to find a stock that you think is overvalued and that you believe is unlikely to rise in price any time soon. You then buy a certain amount of shares of that stock. You also need to buy put options on that same stock. The put options you buy give you the right to sell that stock at the price you bought it at any time over the next few months. The next step in implementing the protective put strategy is waiting for a significant stock price decline. This is when you’ll exercise your put option and sell the stock at the price you purchased it. If the stock price declines, you’ll likely make a profit on your shares and the put options you bought.

Drawbacks of the Protective Put Strategy

We’ve covered a lot of advantages associated with the protective put strategy, but it does have a couple of drawbacks. First, you need to ensure that the stock you buy for this strategy has a low price. This is because you’ll be selling the stock at the price that you bought it at, so you need to make sure that it has a low price so that you can still make a profit by selling it. The other drawback of this strategy is that it’s only effective if the stock price declines. If the price has increased, you’ll likely still have to sell the shares at the price you bought them at, so you won’t make a profit.

Conclusion

The protective put strategy is an advanced options strategy that can hedge a stock position against sharp price declines. Traditionally, investors have used futures contracts to hedge their portfolios. Still, this strategy is a lot more effective for two main reasons. First, futures contracts are actually quite expensive, and they also involve a lot of speculation. Put options, on the other hand, are significantly cheaper and less speculative because they involve owning shares of the stock. Put options are also more effective because they allow you to sell the stock at the price you bought, even if the price declines. This makes them a more effective strategy for protecting your portfolio against sharp declines in the market.