How To Protect Your Falling Stock Using A Protective Put Strategy: Being a long-term investor involves constructing a diversified portfolio of stocks that will help you achieve your long-term goals. While investing in the stocks for the long term you might come across instances where stocks in your portfolio might face significant falls.
But as a long-term term investor, you know the stock is only facing a setback but at the same time, you would also like to protect yourself against the falls. Thankfully, there are various ways in which an investor can protect themselves from market downfalls, and one of the ways is by employing option trading strategies.
In this article, we will discuss how to protect your falling stock using a protective put Strategy.
What Is A Put Option?
A put option is an agreement between two parties to sell an underlying asset on or before the predetermined date and at a predetermined price. Here the buyers of the put option contract have the right but not an obligation to sell the underlying asset for which they will have to pay a premium to the sellers.
For the premium received by the sellers, they will have to give up the right to execution of the contract irrespective of their incurring a profit or a loss.
Read More: What is Put Call Ratio in Options Trading? How to Interpret it?
What Is Protective Put?
A protective put strategy is also referred to as the married put. This is an options strategy that involves buying a put option when the trader already owns a long position in the stock.
The investors who use this strategy want the stock price to increase, but they buy a put option to protect against the decrease in stock price.
How To Protect Your Falling Stock Using A Protective Put?
A protective put strategy can be employed by investors when they have purchased a stock intending to hold it for the long term but they expect the price of the security to fall in the short run.
In this strategy, the put option acts as insurance against decreasing prices of the stock because when the price decreases, the value of the put options increase, which in turn nullifies the losses in your long position. Thus, this strategy protects your falling stock from losses.
While executing this strategy, the quantity in the lots that are bought should match the number of shares that you hold in the cash market. Suppose, you hold 1000 shares of company X, and its options contracts trade in the quantities of 100 per lot. Then, you are supposed to buy a put option of 10 lots to execute a protective put strategy.
The cost of hedging the losses in the stock is the amount of premium that you pay when you purchase the put option.
Maximum Profit In Protective Put Strategy
As the underlying stock can increase indefinitely, the potential profits can be unlimited. Although, one has to deduct the premiums paid towards the put option from the profit.
The Maximum Loss In The Protective Put Strategy
The maximum loss one can incur in this strategy is the amount arrived at after deducting the stock price from the strike price and adding the premiums paid.
Example Of A Protective Put Strategy
Let’s assume you enter a Protective Put on ABC Ltd to hedge against possible losses, which is trading at a price of Rs.500. To execute this strategy, you buy an out-of-money put option at the strike price of Rs 450 by paying a premium of Rs.30.
In this case, your breakeven point will be Rs.500 + Rs.30= Rs.530. If the stock you hold moves beyond this level, you will start earning profits
The maximum risk in this position will be Rs.500 – Rs. 450 + Rs.30 = Rs. 20.
Impact Of Strike Price And Premiums On Protective Puts
The cost incurred for implementing the trading strategy depends on the strike price at which you purchase the put option contract.
Purchasing at-the-money options will provide investors with complete protection against the fall in the share price. But the premium you have to pay for at-the-money strike prices is comparatively high.
On the other hand, the premiums that you pay for out-of-money options are much cheaper than at-the-money options. But at the same time, this contract will not provide complete protection against losses.
Impact Of Time Decay On A Protective Put
As the put option nears the expiry date, the value of the options contracts that are at the money and out of money keeps decreasing as a result of time decay. However, the intention of purchasing a put option contract is not to earn profit but it is to protect the long-term stock against price falls
Impact Of Volatility On A Protective Put
When there is an expectation for the price of the underlying asset to move significantly in any direction, the volatility of that asset increases. This results in an increase in the price of the premiums and the at-the-money strike prices become very expensive.
When there is high volatility in the security, one can select an out-of-money option as the security will cover that distance more quickly.
Learn More: Sign up for Fingrad’s free stock market courses to protect your investments and maximize your returns today!
In Closing
In this article, we discussed protective put and how to protect your Falling stock using the protective put strategy.
Protective puts are an excellent alternative to the traditional technique of selling shares and a good strategy to prepare for unexpected events. However, one should use this strategy only when one expects a huge downfall in the stocks, as using this strategy repeatedly will depreciate your long-term gains in the stock.
FAQ:
What to do when your stock drops?
Stay calm and evaluate the reason for the drop. Consider if it’s a short-term fluctuation or a long-term issue with the company. Review your investment strategy and determine if you need to adjust your portfolio.
Who gets money when stocks fall?
When stocks fall, investors who sell their shares at a lower price than their purchase price lose money. Other investors may profit by buying shares at a lower price and selling them when the price increases.
How can you protect your stocks from falling?
Diversify your portfolio across different sectors and industries, and consider investing in defensive stocks with stable earnings and dividends. Keep an eye on market trends and news, and have a long-term investment horizon.
Tag: How To Protect Your Falling Stock, How To Protect Your Falling Stock in india, how to protect investments from stock market crash, what to do in falling stock market, what happens to a company when stock prices fall, what to do when your stock drops, what to do if stock prices fall, what does it mean when stock prices drop, Protective Put Strategy.