If you hold stock in your portfolio, you naturally worry about the possibility that their value might fall. The potential volatility of the equity markets can be of great concern to investors. The covered call strategy affords a small amount of downside protection (by the amount of the premium received), but buying a put gives an investor complete protection from a drop in the stock price below the strike price of the put.
This strategy, often called a protective put, is actually more conservative than the simple purchase of stock. As long as a put is held against a stock position, there is limited risk. You know at what price the stock can be sold. The only disadvantages are (a) that money will not be made until the stock moves above the combined cost of the stock and the put and (b), that the put has a finite life. But once the stock price rises above the total cost of the position, an investor has the potential for unlimited profit.
Buying a protective put involves the purchase of one put contract for every 100 shares of stock already owned or purchased. Purchasing a put against stock is similar to purchasing insurance in that the investor pays a premium (the cost of the put) to insure against a loss in the stock position. No matter what happens to the price of the stock, the put owner has the right to sell it at the strike price of the put any time prior to expiration. The risk graph below illustrates the limited risk and unlimited profit potential for this strategy.
The protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the life of the put contract, unless he sells his stock. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react.
Remember that the enemy of any option buyer is time. The time value portion of the protective put will steadily decrease with the passage of time, and this decrease accelerates as the option contract approaches expiration. But the investor employing the protective put is free to sell his stock and/or his long put at any time before it expires. For instance, if the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining.
If the put option expires and has no value, no action needs to be taken; the investor will retain his stock. The only decision to be made is whether current market conditions still warrant protecting the stock. If so, simply buy another put farther out in time. The same technique of rolling options we described earlier with the covered call works just as well with the protective put. If the put closes in-the-money, the investor has two choices; he can exercise the right to sell the underlying stock at the strike price, or simply sell the put to close it, using the profits received from the put to offset any loss from the decline in the stock price.
The put does not have to be purchased at the same time as the stock. A common way to employ the protective put strategy is to buy a put after the stock price has already increased. If an investor has concerns about downside market risk or is afraid the stock price might fall back in the short-term, he can protect his unrealized profits using a put, without having to sell the stock. The put can always be sold later for what value it has when the uncertainty has passed.