A protective put is a strategy that involves buying a put to protect the downside on a stock that you already hold in your portfolio. This week, we explore whether a protective put strategy is optimal.

Why protect

If you hold a stock in your portfolio, your objective must be either to gain from capital appreciation or from income returns (dividends despite higher tax rate). If you want to capture capital appreciation, you should actively trade the stock. That means you should be willing to close a position when you anticipate an adverse movement in the stock that can hurt your existing unrealized gains or increase your unrealized losses. If you are holding the stock for income returns, you should be indifferent to the short-term movement in the stock price. So, why consider buying a put as a insurance protection for the stock?

There is an emotional side to the strategy. All of us prefer to take profits in the short term. But when faced with unrealized losses, we typically tend to extend our time horizon to avoid the regret of having to sell at a loss. So, for most, holding the stock for a long term is a way to avoid taking losses, not necessarily a pre-determined strategy. Given this, buying puts to protect a stock that you hold for a long term may not be optimal. Why?

The closer the put strike is to the current price, the greater the premium you must pay for the downside protection. If you want to reduce your insurance cost, then the protection is less. Suppose you hold a stock whose current price is 800. Then buying a 750 put for 30 points would mean your insurance protection starts if the stock declines below 720, the breakeven price. On the other hand, if you buy the 800 put that could cost 60 points, your breakeven is higher at 740. You can compare the premium (cost) with the deductible in insurance; the more deductible you are willing to take, the lower the insurance cost. But if you are intending to hold the stock for a long term, how often will buy such protection, given that for most underlying, only near-month equity options are liquid?

Finally, consider this. The put premium you pay will consist of only time value, as you are likely to buy either at-the-money (ATM) or out-of-the-money (OTM) put. The issue is that time value of the option becomes zero at expiry. This means you will incur a loss on the option if you hold the put till expiry. The loss in time value must be made good through gains from intrinsic value. And that means you want the stock to decline during the life of the put. But that view conflicts with the long position on the stock!

Optional reading

Whether you intend to hold the stock in your core portfolio or in your trading portfolio, buying a put does not seem optimal if your objective is to protect the downside on your stock. This argument assumes important considering that only the near-month equity options are liquid. That means you are buying downside protection only for a short term. The issue is that time decays faster for short-term options compared to long-term options.

You can reduce loss from time decay by setting up a bear put spread, which involves shorting a same-month lower strike put against a higher strike put. Your intended protection can be achieved if the stock declines but stays above or at the lower strike at option expiry.

Note that there is a subtle difference between protective put and married put. The former refers to buying a put to protect the downside on an already-held stock. The latter refers to buying a put along with the stock. The above discussion applies to both these strategies.

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