An investor who purchases a put option while holding shares of the underlying stock
from a previous purchase is employing a "protective put."
Bullish on the Underlying Stock
The investor employing the protective put strategy owns shares of underlying stock
from a previous purchase, and generally has unrealized profits accrued from an increase
in value of those shares. He might have concerns about unknown, downside market
risks in the near term and wants some protection for the gains in share value. Purchasing
puts while holding shares of underlying stock is a directional strategy, but a bullish
one.
Like the married put investor, the protective put investor retains all benefits
of continuing stock ownership (dividends, voting rights, etc.) during the lifetime
of the put contract, unless he sells his stock. At the same time, the protective
put serves to limit downside loss in unrealized gains accrued since the underlying
stock's purchase. No matter how much the underlying stock decreases in value during
the option's lifetime, the put guarantees the investor the right to sell his shares
at the put's strike price until the option expires. 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. Alternatively, a previously entered stop loss limit order on the
purchased shares might be triggered at both a time and a price unacceptable to the
investor. The put contract has conveyed to him a guaranteed selling price at the
strike price, and control over when he chooses to sell his stock.
Maximum Profit: Unlimited
Maximum Loss: Limited
Strike Price - (Stock Purchase Price + Premium Paid)
Upside Profit at Expiration: Gains in Underlying Share Value Since Purchase - Premium
Paid
Potential maximum profit for this strategy depends only on the potential price increase
of the underlying security; in theory it is unlimited. If the put expires in-the-money,
any gains realized from in an increase in its value will offset any decline in the
unrealized profits from the underlying shares. On the other hand, if the put expires
at- or out-of-the-money the investor will lose the entire premium paid for the put.
BEP: Stock Purchase Price + Premium Paid
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option's total premium is on the time value portion.
Passage of Time: Negative Effect
The time value portion of an option's premium, which the option holder has "purchased"
when paying for the option, generally decreases, or decays, with the passage of
time. This decrease accelerates as the option contract approaches expiration. A
market observer will notice that time decay for puts occurs at a slightly slower
rate than with calls.
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 with no value, no action need be taken; the investor will
retain his shares. If the option closes in-the-money, the investor can elect to
exercise his right to sell the underlying shares at the put's strike price. Alternatively,
the investor may sell the put option, if it has market value, before the market
closes on the option's last trading day. The premium received from the long option's
sale will offset any financial loss from a decline in underlying share value.