Chapter 15: Understanding Protective Put Strategy

 Simran, Abhinav’s manager, asks for his opinion to deal with a particular query that she has. She asks him to suggest a strategy that would protect from loss on a long delivery position. After giving it some thought, Abhinav suggests a Protective Put.

Do you remember?

Hedging is a tool to reduce risk in financial transactions. 

Protective Put

A Protective Put is a strategy to safeguard against losses from a long position in a stock. This strategy involves a long position in stocks and buying an OTM Put on the stock. The Put Option safeguards you from a loss on a long delivery position.

• This will work as an insurance or stop loss against your open long position in a stock.
• A Protective Put strategy will help you hedge your long position.

Strategy: Long position in the stock (you own the stock) + long OTM Put Option

When to use: When you are bullish on the underlying but want to protect downside risk

Breakeven: Stock price + Premium paid on a Put Option

Maximum profit: Unlimited, (Stock closing price – Premium paid)

Maximum risk: Stock price – Strike price of the Put Option + Premium paid

Let us understand this with an example:

Let’s assume Simran instructs Abhinav to enter a Protective Put on ABC Ltd. She wants to hedge against possible losses. Assume that the spot price of ABC Ltd. is Rs. 1,000. Abhinav buys an ABC Ltd. OTM Put Option at a strike price of Rs. 900 at Rs. 50. He pays a total premium of Rs. 50 and the breakeven point in this case will be Rs. 1,000 + Rs. 50 = Rs. 1,050. The maximum profit could be unlimited, as the stock price can move to any level. The maximum risk in this position will be Rs. 1,000 – Rs. 900 + Rs. 50 = Rs. 150.

Let’s look at the cash flow in the various scenarios:

Let us understand the payoff in various scenarios. It will give you a fair idea of how we have arrived at the above values. 

If the stock closes at Rs. 800 on expiry: The long Put Option will expire ITM

The purchase price of the stock = Rs. 1000

The selling price of the stock on expiry = Rs. 800

So, the payoff from the spot position = Selling price – Purchase price = 800 – 1000 = – Rs. 200

Premium paid on the OTM Put Option of strike price Rs.900 = Rs. 50

Premium received on OTM Put Option of strike price Rs. 900 at expiry = Max {0, (Strike price – Spot price)} = Max {0, (900 – 800)} = Max (0, 100) = Rs.100

So, the payoff from the OTM Put Option = Premium received – Premium paid = 100 – 50 = Rs. 50

Net Payoff = Payoff from the spot position + Payoff from OTM Put Option = (– 200) + 50 = – Rs. 150 

If the Stock closes at Rs. 1050 on expiry: The long Put Option will expire OTM

The purchase price of the stock = Rs. 1000

The selling price of the stock on expiry = Rs. 1050

So, the payoff from the spot position = Selling price – Purchase price = 1050 – 1000 = Rs. 50

Premium paid on the OTM Put Option of strike price Rs. 900 = Rs. 50

Premium received on OTM Put Option of strike price Rs. 900 at expiry = Max {0, (Strike price – Spot price)} = Max {0, (900 – 1050)} = Max (0, – 150) = 0

So, the payoff from the OTM Put Option = Premium received – Premium paid = 0 – 50 = – Rs. 50

Net Payoff = Payoff from the spot position + Payoff from OTM Put Option = 50 + (– 50) = 0

If the stock closes at Rs.  1200 on expiry: The long Put Option will expire OTM

The purchase price of the stock = Rs. 1000

The selling price of the stock on expiry = Rs. 1200

So, the payoff from the spot position = Selling price – Purchase price = 1200 – 1000 = Rs. 200

Premium paid on the OTM Put Option of strike price Rs.900 = Rs. 50

Premium received on OTM Put Option of strike price Rs. 900 at expiry = Max {0, (Strike price – Spot price)} = Max {0, (900 – 1200)} = Max (0, – 300) = 0

So, the payoff from the OTM Put Option = Premium received – Premium paid = 0 – 50 = – Rs. 50

Net payoff = Payoff from the spot position + Payoff from OTM Put Option = 200 + (– 50) = Rs. 150

Additional Read: Five key parameters to look for before buying an option

Summary

• Hedging is a tool to reduce risk in financial transactions. 
• A Protective Put is a strategy to safeguard against losses from a long position in a stock.
• This strategy involves a long position in stocks and buying an OTM Put on the stock.
  • Breakeven: Stock price + Premium paid on a Put Option
  • Maximum profit: Unlimited, (Stock closing price – Premium paid)
  • Maximum risk: Stock price – Strike price of the Put Option + Premium paid