Let us understand what is protective put strategy using an example-
Consider an investor who is holding shares presently trading at $520.00. His investment horizon is 6-months. In 6-months' time, share price can either rise or fall. To protect himself from a substantial fall (to hedge the downside of the distribution) in share price, investor enters in to a PUT option contract to have a right to sell the shares if the share price falls below a certain price i.e., strike price of $480.00 for which PUT premium of $25.00 has to be paid initially.
Therefore, buying a PUT option at a strike price of $480.00 by paying a premium of $25.00 is known as Protective Put or Portfolio Insurance. It is a costly strategy as it increases the effective cost of holding shares $520 + $25 = $545 (share price + PUT premium). Also, amount which remains unhedged $520.00 - $480.00 i.e., $40.00 is known as deductible.
Note: Protective Put is often described as synthetic long CALL in terms of having similar profit profile. Its profit resembles a long CALL i.e., long CALL at a strike price of $480.00 for a premium of $65.00 (having shares at $545.00 and protecting it from downside of $480.00, the difference being $65.00 is CALL premium).
Example:
Blue thin line represents stock purchased at $520.00 and has the both side fluctuation. Red thin line represents put option purchased at a strike price of $480.00 for $65.00 which do not have the downside risk. Black thick line represents portfolio of stock and put option were protection of downside of $480.00 and the profit from upside is unlimited (uncapped).
Therefore,
Maximum loss = $65.00 (being ($520 - $480) + $25)
Maximum profit = Unlimited (no cap)
Break-even (i.e., equilibrium) = $545.00 (being $520 + $25)
Advantage of doing this strategy:
Protective Put strategy protects an investor from losses due to significant fall in share price (a hedge to the downside risk) - good for those investors who are highly risk averse / having low risk appetite.
Disadvantage of doing this strategy:
Every option contract has an expiry. So continuously buying put option for protection for a longer investment horizon is very expensive and exposes the investor to the risk of not being able to achieve the investment objective.
Recommendation to the investor:
Use this strategy for temporary protection instead of buying continuously put option for a long period investment horizon (as it leads to increase in cost of holding the stock).
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