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Many people think of options as being risky, but some options strategies are designed to reduce risk. Using a protective put, for instance, can help you protect your unrealized gains and limit your maximum loss if you are long the underlying stock and it falls. But even if the stock price keeps going up and the option expires worthless, you still get the upside potential of owning the stock. Let's take a closer look at this options strategy to see why it can indicate a bullish outlook on a stock, and how you can pick a strike price that will work for your needs.

What is a protective put?

A protective put is a combination of two investment positions. First, you need to own the underlying stock. Second, you buy a put option on that stock, giving you the right to sell it within a certain timeframe at a specified price, known as the strike price. In order to buy the put option, you have to pay what's called the premium for the option.

The reason the put is protective is that it limits your potential loss. If the stock falls below the strike price before the option expires, then you can exercise the put option and force the person from whom you bought the option to pay you the higher strike price in exchange for your shares. On the other hand, if the stock stays above the strike price, then you won't exercise the option, letting it expire worthless.

How a protective put resembles insurance

It's particularly appropriate with protective puts that the price you pay to buy an option is called the premium because in many ways, using protective puts is like buying insurance. Much of the time, you simply lose the premium because you don't suffer the loss you've insured yourself against. Sometimes, though, when the stock does suffer a major loss, you'll exercise your put option and end up far better off than if you hadn't used the strategy.

As an example, say you bought a stock at $50 and it has risen to $105. You want to protect your gains without selling the stock, and so you decide to buy a protective put with a strike price of $100. Say you pay $5 for that option. In that case, there are several ways the strategy can play out:

  • If the stock rises to $120, then you won't exercise your option, and it will expire worthless. You'll be out the $5 you paid for the option. But the stock has risen $15, so your net profit is $10.
  • If the stock falls to $101, then you won't exercise your option because the market price is still above $100. This is a losing position for you: Not only will you lose the $5 option premium, but you'll also have suffered the $4 decline in the share price.
  • If the stock falls to $80, then you'll exercise your protective put option. The person from whom you bought the option will pay you $100 for your stock. You'll still have suffered a $5 loss on your shares, and you'll still have paid another $5 for the option. However, that total loss of $10 is less than the $25 you would have lost if you had simply held on to the stock without a protective put.

When buying protective puts makes the most sense

Smart investors know that the time to buy most investments is when most investors aren't paying attention to them. The same is true of options. Typically, put options are cheapest during big bull markets, especially when major market benchmarks are climbing strongly. That's because options traders don't value protection highly when the market has upward momentum.

If you wait until a pullback, you'll often find that options prices rise precipitously. Suddenly, investors are interested in the portfolio protection that put options offer, and they're willing to pay up for the insurance value of the options strategy. Therefore, if you think about protective puts when it seems like you don't really need them, then you'll put yourself in the best position to pick them up cheaply.

Protective puts allow you to hold on to shares of stock and retain the prospects for further profit if those shares rise in value, while also letting you set a maximum limit on potential losses. That gives investors the best of both worlds, and that's why the protective put strategy can be so attractive to those who are willing to use options in their overall investing plan.