Chapter 2

Protective Put Option Strategy

One big concern for anyone investing in stocks is timing; no one wants to buy something that goes down in value shortly after purchase. Since you cannot predict the market, there is always a risk that losses could occur. If this risk is what prevents you from investing, there is an ‘option’: the protective put option strategy. 

We have already seen how buying health insurance is similar to buying put options. It relates to the concept of protective put option strategies as well. 

To maintain the insurance policy, you will need to pay on-going premiums to renew the policy. The insurance policy will have various limits which effectively cap the amount of your hospitalisation costs. 

Just like health insurance will help you cover expenses in event of hospitalisation or illness, a protective put option strategy sets a limit on your losses.

What is a Protective Put option strategy?

The Protective Put option strategy is a combination of being long on a stock and a put option. (As a reminder, a put option gives the holder the right, but not the obligation, to sell the stock at a specified price at a predefined date in the future). 

Purchasing a put option by itself is an inherently bearish option strategy, meaning you profit if the underlying security moves down. Combining a stock and a put option allows you to preset a maximum loss on your stock position. 

For example, let’s assume you own stock currently priced at 395. The maximum loss is 395 which would happen in the worst-case scenario of the price going to zero. 

You intend to limit your losses to approximately -2.5%. To ensure this, you purchase a put option with a strike price of 385 at 3.06. How does this work?

Every time the stock decreases in value below 385, the intrinsic value of the put option will increase by a corresponding amount. So, at an underlying price of 375, the stock will have lost -10 from the strike price of 385. However, the put option will have increased in value by +10. 

As a reminder, these are the payoff and profit formulas for a put option:

Key Formulae

• Long Put Payoff = Max(0, Strike Price – Underlying Price)
• Long Put Profit = Long Put Payoff – Option’s Cost

Illustration 1

What is the maximum loss? 

The maximum loss for the protective put strategy is slightly different than that of a put by itself. The maximum loss is the sum of the put option’s cost and the difference between the price of the stock when you purchased the option and the strike price. 

In the example above, the price of the stock when you purchased the put option was 395 and the strike price was 385. The cost to purchase the put option was 3.06. Therefore, the maximum loss for this protective put strategy is 13.06 ((395 - 385) + 3.06).

Key Formulae

Protective Put Maximum Loss = (Underlying Price at Put Option Purchase – Strike Price) – Cost of Put Option

What is the profit potential? 

The profit potential is unlimited because with the protective put strategy, you are still long the underlying stock. However, by executing the protective put strategy, the trader will always underperform only holding the stock by the cost of purchasing the put option. 

In our example, if the stock closed at 415 on expiration, then the profit for the trader of the protective put strategy is 16.94 (415 – 395 – 3.06). 

The stock-only trader would see a profit of 20 which is 3.06 higher than the trader of the protective put strategy. In illustration 2 below, we show the profit diagram for a protective put strategy.

Illustration 2

When would you do this? 

The protective put strategy works best whenever there is a large downward movement in the underlying stock. However, there is a trade-off in performance of this strategy. The more protection for your stock that you want, the higher the cost. 

In illustration 1 above, you can see that protecting against a 2.5% move (395 → 385) costs you 3.06 or 0.8% of the value of the underlying. 

To protect against a 1.27% move (395 → 390) you would have to spend 4.46 or 1.1% of the value of the stock. 

As you can see, if you try to protect against small downside movements, you can end up paying almost as much to hedge as the downside movement itself. On average, the markets move up more often than they move down, so you can’t be too cautious when it comes to implementing this strategy.

Implementation: ‘Uncomfortable number’ method

One way to do this is to select a number that would make you uncomfortable if you lost this amount in a short period of time. That ‘uncomfortable number’ could be your downside number. 

In illustration 3, we provide a backtest of a situation where a virtual trader defined this ‘uncomfortable amount’ as:

• 10% in a month. The particular stock is Tata Motors. 
• In the first row of the table are the returns of the stock. In June, May, April, Mar, and February, the stock had a negative return. 
• The second row lists the returns of the protective put strategy with a strike that is 10% below the current price. 
• The third row shows the difference in performance in the protective put strategy and the stock-only returns. 
• In our backtest, the only month where the protective put strategy outperformed was in February when the stock had a return of less than -10%. Even when the stock had a positive return, the protective put strategy underperformed due to the cost associated with buying the put.

Illustration 3

While this may seem like a very inefficient strategy, the backtest above only represents a simple buy-and-hold until expiry execution. What this means is that the only way the put option has value is on expiry. 

Perhaps during the first week of the month, the stock price drops significantly and the put value rises in a corresponding manner. During this time, you stress about the impact to your portfolio. The stress is quickly relieved as the price recovers and by the end of the month, the stock is only down a small percent. Due to this, the put option expires worthless and the strategy is of limited use as you didn’t benefit financially. 

Implementation by cashing in on ‘fear’

Warren Buffett has advised that one should be “greedy when others are fearful.” What this means is that the best opportunities to buy are when the markets and individual stocks have suffered a loss in value. The problem is that you need to have cash available in order to take advantage when the markets are turbulent. 

One way to do that is to convert a put option that has intrinsic value to cash. You can then use this cash to re-invest in the markets. Illustration 4 shows a backtest where the trader either holds the put option until expiry or sells whenever it is in-the-money. In our backtest, we are once against purchasing put options that are 10% out-of-the-money or 10% below the current underlying price of Tata Motors. 

• In the months of June, May, and March, our backtest exits the put option prior to expiration. 
• In June, we virtually sold the put option on 17 June at a price of 5.65. For the month, the protective put strategy has a -2.8% return but this is better than the -4.1% return of the underlying stock. This -2.8% monthly return is even better than the -5.7% return if the trader were to merely hold the put option until expiration. What this backtest does not assume is the gain of the put if it is then re-invested in the underlying. This could possibly result in an even higher return.
  

Illustration 4

By implementing this subtle change in trade execution logic, the put protection strategy is successful by outperforming the stock-only trade whenever Tata Motors has a negative return. This will not always be the case but this backtest shows the power of this strategy when it comes to reducing losses. Of course, whenever the underlying stock has a positive return, the put protection strategy underperforms by merely holding the underlying stock.

To Conclude: 

• Combine being long on a stock and a put option to construct a Protective Put option strategy.
• This strategy allows you to preset a maximum loss on your stock position.
• This strategy works best whenever there is a large downward movement in the underlying stock.
• Higher the protection you seek for your stock, higher will be the cost you pay for the strategy.
• Maximum loss is the sum of the put option’s cost and the difference between the current value of the stock at option purchase and the strike price. 
• The strategy has unlimited profit because you are still long on the underlying stock.

Key Formulae

• Long Put Payoff = Max(0, Strike Price – Underlying Price)
• Long Put Profit = Long Put Payoff – Option’s Cost
• Protective Put Maximum Loss = (Underlying Price at Put Option Purchase – Strike Price) – Cost of Put Option

That brings us to the end of this chapter on a protective put strategy. In the next chapter, we will see what happens when you sell a call and buy a put option on the same stock. See you there.