Directional Corner - Articles

The Protective Put Strategy

As a reminder, a put gives an owner the right but not the obligation to sell a certain stock, at a specific price, by a specified date.

For this opportunity, the buyer pays a premium. The seller, who receives the premium, is obligated to take delivery of the stock should the buyer wish to sell the stock at the strike price by the specified date. A strategically used put offers maximum protection against substantial loss.

The Protective Put, also referred to as a "married put," "puts and stock" or "bullets," is an ideal strategy for an investor who wants full hedging coverage for their position.

Whereas the Covered Call Strategy will cover an investor down only as far as the premium he receives, the protective put strategy will protect the investor from the breakeven point down to zero.

This strategy's philosophy is different from the covered call (buy-write) strategy in two major ways.

The covered call is a premium selling strategy, while the protective put is a premium purchasing strategy; and the covered call is most effective in a less volatile situation while the protective put is more effective in high volatility situations.

When an investor purchases a stock, he can either sell the call (buy-write) or buy the put (protective put) to provide a proper hedge. The construction of the protective put position is actually quite simple. You buy the stock and you buy the put on a one to one ratio meaning one put for every one hundred shares of stock.

Remember, one option contract is worth 100 shares. So if we have 400 shares of IBM then you would need to purchase exactly four puts.

From a premium standpoint, we must keep in mind that by purchasing an option, we are paying out money as opposed to collecting money. This means that our position must "outperform" the amount of money that we put out which is the opposite side of what we did in the covered call strategy.

If we were to pay $1 for a put and we owned stock against it, we would need to have the stock increase in price $1 just for us to break even. Unlike the covered call, the protective put strategy has the premiums working against it, thus the stock needs to move more to offset the cost of the put.

This is why long option strategies need more volatility than short option strategies. Earlier we talked about the covered call strategy needing to be done over a decent period of time (a year or so) in order to take advantage of the odds.

We stated that selling options and collecting the premium was the right thing to do 75% to 82% of the time. If this is true, then buying an option and paying out premiums is only going to be right 18% to 25% of the time.

Those are not good odds. So you should try to stay away from employing this strategy over a long period of time to avoid having the odds fall against you. However, employing a protective put can be extremely effective in the proper situation.

Let's take a look at the risks and rewards of the protective put strategy over three different scenarios.

As previously stated, when we buy a stock, three potential outcomes exist. The stock can go up, go down, or remain stagnant. Let's hypothesize results across these three scenarios. Say you buy the stock for $31 and buy the front month 30 put for $1.

In the "up" scenario, let's assume the stock price is $31.50 at expiration. The results are that you have a $0.50 gain from capital appreciation and a $1 loss from the purchase of the put which combined gives us a $0.50 overall loss.

It is important to realize that the up scenario will only produce a positive return if the stock gain is greater than the amount paid for the put. That being the case, you calculate the breakeven point for the protective put strategy by adding the purchase price of the stock to the price of the put.

In the "up" scenario, add the stock price $31 plus the option price $1 and you get a breakeven of $32. So until the stock reaches $32, the position will not produce a positive return. Above $32 the position will gain the amount equal to the stock price minus the premium paid for the option.

In the "stagnant" scenario, the position will produce a loss. Since the stock hasn't moved, there will be no capital gain or loss and with the stock at $31 at expiration, the puts are worthless. The position lost $1, the amount you paid for the puts.

In the "down" scenario, the position will again produce a loss. If the stock price were to trade down $1 to $30, then you would have a $1 capital loss.

With the stock at $30, the 30 puts will be worthless, thus you incur a $1 loss because that is what you paid for them. Your total loss will be $2.

However, in the "down" scenario, the protective put will set a cap on your losses. Let's see how that works. We'll set the stock price down to $28. Since you purchased the stock at $31, there will be a capital loss of $3.

The puts, however, are now in the money with the stock below $30. With the stock at $28, the 30 puts are worth $2. You paid $1for them so you have a $1 profit in the puts.

Combine the put profit ($1) with the capital loss (-$3) and you have an overall loss of $2. The $2 loss is the maximum amount you can lose regardless of how low the stock declines, even if it goes as low as zero. This is what is meant by maximum protection.

In every protective put position it is possible to calculate your anticipated maximum loss. Use the formula: (stock price minus strike price) minus the option's price equals total maximum loss.

Maximum Loss = (Stock Price -- Strike Price) -- Option Price

For example, suppose you paid $30 for your stock. You bought the front month 27.5 put for $1. Next, assume the stock closes at $27.50 on expiration day.

Your maximum loss calculation would be:

($30.00 --$ 27.50) - $1.00 = $3.50

$300 (stock price) minus 27.5 (strike price) equals a $2.50 capital loss. Do not forget that with the stock at $27.50, the 27.5 puts will be worthless.

Add the capital loss ($2.50) plus the option loss ($1). The total is $3.50 which is your maximum possible loss in that position. This formula will work every time.

Looking at the three hypothesized scenarios, we find that only one scenario, the "up" scenario, can produce a positive return and that's only when the stock increases more than the amount you paid for the puts.

The other two scenarios produced losses. If the stock is stagnant, you lose the amount you paid for the put. If the stock goes down, you lose again- but the loss is limited. It is the limiting of loss that makes the protective put an attractive and useful strategy.

The Protective Put Strategy can be adjusted to address the particular lean that the stock owner has at a particular time. (The term lean describes the stock owner's perception of the directional strength of the stock.)

At any given time, an investor could feel that a stock may go up or down, a little or a lot, or just stay where it is. The protective put is not a position you would put on if you feel that the stock you own was going to consolidate for a while. You would have a loss in the stagnant lean scenario since the stock made no gain but you were out $1for the purchase of the put.

However, the situation is different in a bullish lean scenario.

A stock that has the potential to rise quickly also has the potential to fall just as quickly. A stock that has substantial potential gain has an equal potential loss.

An investor choosing to buy a stock like this should have more protection to the downside then a covered call can provide and at the same time more allowance for a larger upside potential than the covered call allows.

This is a perfect time to use the protective put strategy. The purchase of an out-of-the-money put will be a relatively inexpensive investment but will provide the kind of results that will best fit a bullish lean.

You will have maximum downside protection with all the room you need for your stock's potential run up. Of course, this comes at a price. You must pay for the protection and freedom this position can provide.

The protective put can also be used when you have a little bearish lean on your stock. Let's say that you own a stock that has taken a very nice run up. The stock has gotten to a point where you think about possibly selling and taking your profits but are afraid to because you feel it may still run up more and you will not forgive yourself for getting out too early.

Instead of selling the stock and missing out on the continued run, look into buying a put for protection. It will allow you to continue your capital appreciation as the stock trades up while limiting your loss to a fixed, known amount.

In cases such as this one, the purchase of an at-the-money or slightly in-the-money put will ensure you get a good sale price if the stock heads down and allows you ongoing profit if the stock continues up.

Of course, if the stock stays still, you would lose the amount of premium you spent on the put. If the stock goes up, it would have to trade higher than the amount you spent on the put before your long stock's upward movement starts to make you money again.

Key Point

The protective put strategy, when used correctly, allows investors to take advantage of some opportunities that could provide large potential gains without being exposed to the severe risks that normally accompany such risky opportunities. With the proper protection in place, the investor can profit from aggressive upside moves in the stock while having a fixed, limited loss.

As stated before, this strategy is not going to work all the time. However, there are some especially favorable opportunities for implementing the protective put strategy.

One is the case of a stock in the process of a steep decline. Quite often, stocks experience bad news or break down through a technical support level and trade down to seek a new, lower trading range.

Everyone wants to find the bottom to buy and go long, catching the technical rebound, or to start accumulating the stock at lower levels for the longer term.

Although this scenario sounds good, these types of trades are risky. The risk is in identifying the true bottom. A stock that is in a freefall or rapid decline might give a false indication of a bottom which could lead to substantial losses. The protective put will provide protection against this kind of substantial loss.

A stock that goes through a freefall finally "exhausts" or works through the sellers. The stock proceeds down to lower levels where sellers are no longer interested in selling the stock.

At this level, the stock consolidates and buyers move in. Because the sellers are now done (exhausted) the pressure is lifted from the stock and it proceeds up as buyers out-number sellers.

There are models that are used to calculate where this bottom may lie, commonly referred to as "exhaustion models." The problem is that the stock, on the way down, may stop and give the appearance of exhaustion but then continue further down. If you had bought at the false appearance of exhaustion, you could be looking at a big loss.

There is a potential for a very big reward if you pick the "right" bottom. However, with the big potential gain comes the big potential loss that is common in these types of risk/reward scenarios. Here is a perfect opportunity to employ the protective put strategy!

Remember, the protective put allows for a large potential upside with a limited, fixed downside risk. If you feel that the stock has bottomed out and is starting to consolidate, you purchase the stock and purchase the put.

If you are right, and the stock runs back up, the stock profit will well exceed the price paid for the put. Once the stock trades back up, consolidates, and develops its new trading range, the need for the protective put is over. At this time, if you still like the stock and want to hold on to the long position, you could always start selling calls against it.

Use the formula for maximum loss discussed earlier. Calculate the loss in the stock and the amount you paid for the put and add them together for your maximum loss in this position. The protective put has limited your loss.

Maximum Loss = (Stock Price -- Strike Price) -- Option Price

This protection will save you enough money when you pick a false (wrong) bottom that you may, if you like, try to pick the bottom again at a lower point. The exhaustion scenario, as described here, is a perfect opportunity to apply the protective put strategy.

As seen with the exhaustion example, the protective put strategy is best used in situations where the stock has a potential for an aggressive upside move and the chance of a big downside move.

Another potential opportunity for using the protective put is in combination with Technical Analysis. Technical Analysis is the study of charts, indicators oscillators, etc. Charting has proven to be more than reasonably accurate in forecasting future stock movements.

Stocks travel in cycles that can and do form repetitious patterns. These patterns are predictable and detectable by the use of any number of charts, indicators and oscillators.

Although there are many, many forms and styles of technical analysis, they all have several similarities. The one we want to focus on is the technical "break-out." A break-out is described as a movement of the stock where its price trades quickly through and beyond an obvious "technical resistance" or resistance point.

For a bullish breakout, this level is at the very top of its present trading range. Once through that level, the stock is considered to have "broken out" of its trading range and will now often trade higher, and establish a new higher trading range.

The "break-out" is normally a rapid, large upward movement that usually offers an outstanding potential return if identified properly and acted upon in a timely fashion. However, if the break-out fails, the stock could trade back down to the bottom of the previous trading range.

If this were to happen, you would have incurred a large loss because you would have bought at the upper end of the previous trading range. As you can see the "break-out" scenario is an opportunity that has large potential rewards but can on occasion, have a large downside risk.

Therefore, this is an excellent scenario for application of the protective put strategy.

For example, XYZ is presently at the top of a trading range with the upper end of the range being $66 and the bottom end of the range being $58. When your technical indicator identifies the break-out of the stock (when it trades through $66), you would buy the stock immediately.

The risk of the stock not following through with its breakout is not large but it does happen. The stock could trade back down to $58 which is the bottom of the trading range. If you had bought the stock naked above $66.00, you would realize a minimum $8 loss.

However, if you were to apply a protective put strategy with the stock purchase, you can drastically limit your downside exposure. For instance, say you were to buy the 65 strike put for $2. If the stock trades up to $75, you would make $9 if done naked but only make $7 if done with the protective put.

This difference is the cost of the put. This $2 investment is more than worth it should the stock go down. If the break-out turns out to be a "false" break-out and the stock reverses and trades down, your 65 put will allow you to sell your stock out at $65 minus the $2 you paid for the put. This limits your loss to $3 instead of a potential $8 loss. This is a much better risk-reward scenario.

Below, let's look at three examples where the protective put could have been used effectively.

RJR Chart -- Protective Put Example #1

Source: Quote.com^®

NOTES ON RJ REYNOLDS (RJR)
Protective Put

1. Up until early March 2003, RJR was in a trading range with a high of $47.50 and a low around $38.

2. In early March, RJR broke that low around $38 and traded down to around $28 before trading back up to the $38 level. It failed to break that resistant level a couple times. Then, in mid-September 2003, RJR gaps up and breaks the resistance level.

3. Normally, when a stock breaks a resistance level, it normally trades up to find a new range most specifically a top of the range. Often, there is an opportunity to make a large gain in a very short amount of time when a stock beaks a support or a resistance.

4. After breaking out of the previous trading range, in mid-September 2003 at a price of about $40, RJR trades up to $60 by mid-December 2003. This represents a 50% gain in approximately 3 months.

Conclusion: RJR offers investors two opportunities to use the protective put strategy and in two different ways.

First, the protective put strategy can be used to provide protection when an investor tries to pick the bottom in a stock. The wrong bottom can cost the investor dearly if they buy the stock naked. The put will limit and control the loss, allowing the investor to be wrong, but still allow the opportunity to hold out or play again.

Second, RJR later shows what a stock can do when breaking out of a technical resistance. It can provide investors with large potential gains. However, the fact is that stocks that do break out can, and sometimes do, fail and trade down to the bottom of the stock's previous range. This can leave you with a large loss.

The protective put strategy provides maximum protection in case of a false break out, while allowing for full capital appreciation less the cost of the put if the break out is real.

AMGN Chart -- Protective Put Example #2

Source: Quote.com^®

NOTES ON AMGEN (AMGN)

Protective Put

1. With the use of Technical Analysis, Amgen is identified to be poised to break down through a technical support as determined by a line drawn through three bottoms points, occurring in January 2002.

2. Then, in May 2002, the stock breaks down below the support line indicating an upcoming drop to a new, lower trading range.

3. The stock begins to consolidate at around $46, and attempts to rebound. A protective put can be used here with the purchase of the stock in case the stock has a false bottom.

4. Indeed, this level is a false bottom as the rally fails, and the stock heads lower before the next consolidation level at point around $41. Again, stock may be purchased here with a protective put.

5. The rally fails again and the stock falls to around $32, before putting a final bottom & reversing. Again, a protective put can be purchased here to guard against further downside. At this level, the stock begins its real rally and rises quickly from this point to provide an outstanding return from $32 to a high of $72 in one year.

4. In September 2002 at a stock price around $41, you could also buy a protective put as the stock pauses in its uptrend before continuing higher. At this level, the stock could be gathering up strength for the next leg of the rally (which it does) or it can become tired and begin to trade down again.

Conclusion: The protective put allows the investor the room to be wrong by limiting the total loss. Because the loss is limited, the protective put investor has a staying power not afforded to naked stock buyers who would feel the full brunt of the loss.

This ability to play again increases the protective put buyer's chance of being right and therefore more profitable than the naked stock buyer would be. The Amgen chart is a textbook example of a stock in position for the use of the protective put strategy.

Obviously, this was a risky trade, but one that could, and in this case did, provide an outstanding return. This is the perfect time to use the protective put. The protective put provides maximum protection in risky situations while allowing you to have almost the maximum available upside.

So if you did buy the wrong bottom, the put would have bailed you out by limiting your downside and saving you enough money to try again. As you see from the chart, within 12 months of the July 2002 low of around $32, the stock traded to a high of over $72. This profit is more than enough to have covered the purchase of a few puts.

As stated earlier, this is a textbook case and one that should be studied for its value of properly showing why and when to use the protective put.

WMTChart -- Protective Put Example #3

Source: Quote.com^®

NOTES ON WAL-MART (WMT)

Protective Put

1. In mid-November 2003, Walmart opens down $1.50 to $56.25 and proceeds to trade down from there breaking the lower end of an uptrend channel.

2. Wal-mart then has a quick consolidation in mid-November around the $54.50- $55 level followed by a small technical rebound back to around $56.25. This may have been due to some investors thinking that the consolidation was a bottoming and thus a buying opportunity.
   
   As it turned out, it was a false bottom and the stock traded back down rapidly to lower lows. A purchase at that level probably led to losses.

3. In early December, Walmart starts another consolidation around the $52.50 level. It seems to be another buying opportunity for bottom fishers. There has already been one false bottom that has cost someone a lot of money. If that investor employed a protective put, the loss would have been limited and they may have been able to purchase again at this level if they wished.

4. The $52.50 level turns out to be another false bottom and the stock trades down another $2.00 to $50.50. Here again, the same opportunity exists. Is this the bottom? If it is, a nice profit can be made quickly. If not, losses can mount quickly as another false bottom occurs and the stock trades down rapidly. This level, so far, turns out to be a good buying opportunity as the stock rebounds back up to $52.50 quickly.

Conclusion: Bottom fishing can be a very risky endeavor; however, an investor can not ignore the potential reward that comes with the risk. If the risk can be minimized without affecting the potential reward to a significant degree, the risk-reward scenario will be an advantageous one for a potential investment.

The protective put will accomplish this perfectly. In a case like this, the protective put strategy should be employed at any level where the investor deems it worthy of a capital commitment.

GM Chart -- Protective Put Example #4

Source: Quote.com^®

GM General Motors
Protective Put

1. After trading in a tight range for a considerable period of time with low volatility, GM's volatility spiked in early December 2003 and the stock gapped open considerably higher, followed by another breakout gap opening several days later.

2. This second gap opening forced the stock up through a previous resistance level, as the stock broke out and began a new, higher trading range.

3. The stock then advanced five of the next seven trading days with bigger intraday ranges than average during the previous 12 months, indicating increasing volatility.

4. The initial GM breakout, when it traded through $44 and quickly proceeded to trade up to the $54 range in less than one month, represented a 25% return in a very short period of time.

Conclusion: GM is a perfect example of an opportunity to use the protective put strategy to provide protection against a false break-out when buying a stock on a technical breakout.

In this case, GM had been trading in a lower volatility pattern for several months, which would have kept option premiums down. This would have allowed the investor to purchase the put at an advantageous price.

With the protective put in place, and at a relatively inexpensive price, the investor could ride the break-out with patience and confidence, with limited loss and controlled risk.

Even though this stock was in a rapid uptrend after breaking out of its previous trading range, and the protective puts purchased would have expired worthless, it still would have been a good idea to put on this protection in case the stock pulled in.

Gap openings tend to get filled at some point before proceeding higher, and in the case of a rapid sustained rally, there is usually some type of pullback when the stock is overbought.

In this case, the puts would not have been profitable, but would have provided the necessary protection in case the rally failed, or temporarily retraced.

We wanted to show this example where the puts would not have been profitable, because you never know where the stock is going to go. But even though the puts would have expired worthless, the rise in stock price would have clearly offset the cost of these puts.

So again, the protective put strategy here would have provided a cost effective insurance policy against the stock's pulling back or a failed rally.