Protective Puts & Protective Calls

Why Use Protective Puts & Protective Calls

Quite simply, protective puts and protective calls are hedging strategies that are, usually, used by stock traders that don’t want to liquidate a profitable position but want their profits protected if that position should reverse.

For instance, if a trader or investor had bought stock in Company X at $20 and it then rose to $25, they have made a profit of $5 per share owned. However, that profit isn't realized until they sell those shares, and selling them would mean they were unable to make any further profits if the stock should continue to rise. If the trader believed that it would probably continue to rise, but was also concerned it could start dropping back down in price, then using a protective put would be an ideal solution.

It's basically an insurance policy. There is a cost to put it on, but if the stock falls in value the trader’s previously made profits are effectively covered. If the stock remains at the same price or increases in price then the cost is lost, but that's the price paid for having the insurance.

The protective call is used for very similar reasons, but it's useful when the trader holds a short stock position where the stock has fallen in value and wants to protect against the stock rising up again.

These are among the simplest hedging strategies in existence, and they are commonly used by stock traders.

Advantages & Disadvantages of Protective Puts & Protective Calls

The biggest advantage of these strategies is quite simply that they allow you to keep a profitable position open so you can possibly make further profits, while also ensuring that you don't lose the profits already made from that position. It's hedging in the purest sense really, in that you are basically hedging against the risk of losing money that you have already effectively made.

The biggest disadvantage of this protection is that there's a cost involved in using it, and this cost can then eat into your profit margin. It's ultimately down to you to decide whether the cost is worth it for the protection offered.

Another, less considered, advantage of these strategies is that they can easily be converted into a synthetic straddle if your outlook changes and you believe the stock has become volatile. The synthetic straddle is a synthetic position that is used to emulate the pay-off characteristics of the long straddle, a popular strategy for a volatile market.

Although traders won't necessarily be thinking about such an outcome when using a protective put or call, it's definitely an advantage that might sway you in favor of using these strategies.

How to Use a Protective Put

The protective put is more commonly used than the protective call, simply because stock traders tend to hold long positions more often than short positions. It really is essentially very similar to a long put, because the only transaction involved is buying puts.

However, the long put is used when you are speculating on a security going down in value whereas the protective put is used for the hedging purposes mentioned above or when you have an open long stock position. To create a protective put, you just have to use the buy to open order to purchase enough at the money puts to cover the amount of shares that you own.

So, if you owned 100 shares that were trading at $20, then you would buy one put options contract (each contract typically covers 100 shares) with a strike price of $20. It's usually advisable to buy options that have a few months until expiration.

It really is that simple. If the stock you own continues to go up in price, then obviously your put options would expire worthless, but you would of course make more profits from the stock position. If it went down in price, then your put options would increase in value and cover the losses from the stock position.

You could then exercise the options and sell your stock at the higher price to close your position entirely. Alternatively, you could sell your put options at a profit, and keep the stock position open. Of course, by doing this you would have no further protection if the stock continued to fall in price.

How to Use a Protective Call

The protective call is used when you have an open short stock position that is in profit. Again, it's very simple to create and just the one transaction is involved. You would use the buy to open order to purchase enough call options to cover the amount of shares that you have short sold. The call options should be bought with a strike price equal to the current trading price of the stock you are short on (i.e. at the money call options) and with a few months until expiration.

You are then protected if the stock you are short on starts to rise in price, as your call options will also rise in price. If the stock does start to rise you could exercise your option to buy it, which you could then use to close your short stock position, or you could sell your call options for a profit and leave your stock position open.

Summary

These aren't options trading strategies in the sense that they are used for speculating on the market, but they are brilliant hedging tools and a great example of just how versatile options contracts are. Without options, a stock trader wishing to protect profits from an open position would essentially have to close that position and therefore potentially miss out on additional profits if the stock continued moving in the right direction.

However, by using these hedging strategies correctly it's possible to have the best of both worlds (protection against a reversal and potential for further profits) for what is a comparably cheap premium.