Protective Puts - Protect Your Stockholdings
Jim Graham

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.

Protective Put Performance Graph Example

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