Hedge Strategy: Protective Put
NAME: Protective Put TYPE: Hedge AKA: Married Put ANALOGY/METAPHOR: Purchasing Portfolio or Stock Insurance ACTION: For each 100 shares of stock you own, buy 1 at the money (ATM) put. The strike price = the share price at which your stock is insured. The lower the strike price (i.e. the farther in the money), the less debit/premium paid, but also the less protection gained.
EXAMPLE: After an impressive long run up in share price, The XYZ Zipper Company (a fictional manufacturer of trendy zippers) is trading at $30/share. You sense, however, that demand for all things zippered is growing soft (alas!) But you believe the downturn will be short-lived and that demand, among other things, will rise again. You're convinced, however, that in the short run the stock will trade lower. You choose to purchase some protective puts. You check out the option chains on the stock and see that a $30 put with an expiration date six months out would cost you $3 per contract (or $300 + commissions). Your full "protection" doesn't actually kick in unless the stock trades at or below $27/share. The table below illustrates that the $3 premium also functions in some respects as a kind of deductible.
In this case, what this strategy guarantees is that no matter how low the stock goes during the next six months, you can always cash out at the equivalent of $27/share ($30/share less the $3 premium). Another advantage is that you can still participate in additional capital gains if the stock continues moving higher (although, again, you're still out the $3 premium). VARIATIONS: Although the protective put hedge strategy is fairly simple, it can be adjusted according to your preferences. Perhaps you're willing to accept less downside protection for a less expensive option (equivalent to accepting a higher deductible for a break on your premium). For example, you check the option chains again and see that the $27.50 put for the same expiration date six months out is trading for $1.50. The net result is that in a worse-case scenario, you'll still be able to cash out at the equivalent of $26/share ($27.50 less the $1.50 premium). But the benefit is that you'll be penalized $1.50 less if the stock remains relatively flat or if it moves higher. Another variation to consider is employing a protective put on a less volatile stock. Imagine if the XYZ Zipper Company were a less growth oriented zipper company (e.g. specializing in the slow-growth tent and sleeping bag markets while shunning the high-growth but frequently volatile crotch and purse markets). Perhaps the company is a steady but slow grower and you've grown accustomed to the regular quarterly dividend. It's one of your core holdings, but you want to protect yourself in case of some unforeseen crisis. You have a couple choices. You can purchase some at the money (ATM) protection for a whole lot less (you see that in this case, the same $30 put six months out is available for just $0.75). Or you can choose to guard only against a major crash in the stock by buying a put with a much lower strike price. Again, you check the option chains and find a put with $15 strike price six months out is trading for just $.10. Obviously, the market is pricing in a very low possibility of the stock falling that far, but if the unthinkable happened and the company went bankrupt and the stock quickly went to zero, you could still unload your worthless stock for $15/share. Obviously, you suffered a big loss, but that little bit of insurance saved half your investment.
OTHER: Technically, there is a difference between a protective put and a married put. Protective puts are added to protect a stock position you already own. Married puts, on the other hand, are purchased at the same time you enter a stock position. They go down the brokerage aisle together as it were. The protective put is used to insure a long term holding or one with a recent run up in price while married puts are for the bullish investor who believes a stock will go up but nevertheless wants to limit downside risk.
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