Stock Option Strategy - Protective Put

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Protective put strategy description:

The protective put strategy is designed to hedge underlying security from a potential sharp decline. It consists of a long put position and a long underlying security position.

If the underlying security devaluates, gaining from the long put contract will result, this hedge considered as 'floor' because of its downside hedge characteristics. On the other hand, if the underlying security rises, the investor will benefit from the upside gains and will lose decreasingly from the long put position. Moreover, no matter how low the stock might fall, the investor can exercise the put option contract to liquidate the underlying security at the strike price.

Direction outlook: Probable for an immediate sharp decline, but overall bullish.

Profit potential: Unlimited theoretically, underlying security can rally infinitely high.

Loss potential: Limited. Depends on the strike bought to protect the underlying security we will analyze distinctive situations.

Risk / reward: Relatively low ratio depends on the strike, divided by probable unlimited profit.

Breakeven points at expiration: stock price - premium = strike.

Time factor: All other variables unchanged, an option typically loses time value premium with every passing day, and the rate of time value loses tends to accelerate as it reaches to the end of its term, the expiration date. As with most long option strategies, the passage of time has a negative impact. As time remaining to expiration decreases, the statistical chances of achieving further gains in intrinsic value shrinks, also.

Implied volatility: An increase in implied volatility would positively affect this strategy, all other variables being equal. Volatility tends to boost the value of any long option strategy, because it indicates a greater statistical probability that the stock will move enough to give the option intrinsic value by the expiration day. On the other hand, a decline in volatility has a tendency to lower the long strategy's value, regardless of the overall stock price trend.

Dividends: As you all ready know, the dividend positively affects the long put option contract and the opposite on a long underlying security; thus, the overall effect is negatively minimal and it should not be an issue when considering executing this strategy.

Assignment: If you plan to keep protecting your underlying security, than roll your put position when current time to expiration recommended up until 10 days to the expiration date, as you already know, time decay accelerates as time to expiration ends. Generally, exercising long contracts before expiration is not recommended to because of its remaining time value; however, if you are planning to sell your underlying security or get into a short underlying position as a part of your whole strategy.

Examples
In the following examples, we will analyze buying protective put alternatives.  We will learn to differentiate the level of protection from strike to strike and plan strategies according to the underlying security outlook. Which protective strategy is better for a relatively moderate volatility? What contract is suitable for a high volatility?

It all begins with a proper plan to achieve success.
 
ITM, ATM, OTM Protective Put Strategy

ITM (in the money): Protective put strategy's premium is usually higher. The strategy devaluates less from time decay and less from a change in the implied volatility. Protective put strategy will relatively be more protective from the downtrend and will gain relatively less from a rally of the underlying security. A suitable outlook for the underlying security is very bearish and still wants to hold on to the underlying security.

ATM (at the money): Protective put strategy's premium is usually moderate. The strategy devaluates the most from time decay and affected most by the change of the implied volatility. Protective Put strategy will relatively be protective from the downtrend and will relatively gain from a rally of the underlying security. A suitable outlook for the underlying security is bearish and still hopes for a possible rally.

OTM (out of the money): Protective put strategy's premium is usually the lowest. The strategy devaluates the les from time decay and affected les by the change of the implied volatility. The protective put strategy will be relatively less protective from the downtrend of the underlying security and the most from the underlying security's uptrend. The protective put strategy will gain from a rally of the underlying security. A suitable outlook for the underlying security is more bullish and still has a little concern of a possible downtrend.