What is a protective put?
Put options are a type of contract that give the holder the right to sell a security at a specific price. The price of the contract depends on how close to the current market price the "strike price" is, and how much time is left until the contract expires.
A protective put is a strategy that combines buying stock with buying a put. The ultimate goal is to protect against a possible decrease in the stock's price.
Purchasing a protective put will require you to pay money in the form of a debit. You pay this premium to protect yourself against future risk, but you hope you never have to use it. Traders who use this strategy are willing to pay a small amount to make sure they're protected against defined risk.
Paying the premium will increase the cost of your original stock position. Therefore you should consider the cost of the debit when deciding how and where to protect yourself from risk, and for how long you expect to need the protection.
When to use a protective put strategy
When an investor owns an asset, they might want to protect themselves from future price decreases. Buying a protective put does this by allowing the investor to sell the stock at the protective put's strike price. This way, if the stock price does decrease, they will have already sold it at the higher price and won't lose any money.
If you have a long stock position, and the underlying asset's price increases, you can buy a protective put to limit your losses. If the price of the asset decreases, you can sell the protective put to lock in a profit on your trade.
How to manage a protective put position
Protective puts are bought to protect stock, not to make money from a bet on implied volatility. Because of this, the rate at which time decay occurs is not that important. The traditional goal when using this strategy is for the price of the stock to go up as high as possible and for the protective put to expire without being used.
Protective put maximum profit potential
When you use a protective put, you're not limiting your potential profits. You still own the stock, so you can benefit from any increase in its value.
Protective put maximum loss potential
The risk in using a protective put strategy is limited to the amount you paid for the put option plus the stock's current price minus the strike price.