Can Protective Puts Provide a Temporary Shield?

Say you have some stocks in your portfolio that you don't want to sell. Is there a way you can attempt to temporarily protect those stocks from sharp price drops? Although there are different ways to hedge positions in the stock market, one strategy is to buy a put option contract on a stock you own. This strategy, known as a protective put is a potential solution to help limit your downside risks, but it isn't without its own drawbacks.

When you buy a put option, you enter a contract that allows you to sell 100 shares (typically) of stock on or before a chosen date at a predetermined price known as a strike price. If the price of the underlying stock drops significantly, that put option contract will likely gain in value. This could at least partially offset the losses in the underlying stock. Note: Because put contracts trade in an open market, they can generally be traded throughout a contract's life, but the price of an option is subject to high volatility.

Let's look at an example. Say you own 100 shares of XYZ stock, and it's trading at $130 per share. You don't want to sell the stock, but you're worried about how some news may potentially affect its near-term prospects. So, you elect to buy a put contract. Let's assume the put contract on XYZ has a strike price of $120 that expires in two months, and it trades for $265, or $2.65 per share. If XYZ stock drops to $115 after a month, the put contract may have risen in value to $750. Although this increase in the put contract's price doesn't completely make up for the loss in the 100 shares of stock, it potentially helps reduce the unrealized loss by almost $500, not including transaction costs. If the stock were to drop even more, the "protection" offered by the put option would increase.

Given this temporary protection, why doesn't every investor buy a protective put on every stock? Because of the downsides to a protective put. First, there's an initial cost for the put, known as a premium. This premium is the most an investor can lose on the put, but given the high volatility found in options contracts, there's a strong chance of losing the entire premium. This premium may represent just a fraction of the investment in the underlying stock, but it's something to carefully consider. If the underlying stock price increases rapidly, the loss incurred on the put contract can substantially eat into overall profits, especially if an investor uses the protective put strategy several times.

Another important consideration when buying puts is the role of time decay or theta. Options contracts tend to lose value over time, all else being equal. This time decay may not be obvious if the underlying stock and the options price make a strong move. However, if the underlying stock isn't moving quickly, the option you bought will likely decline in value. When the stock doesn't make a significant decline, a protective put will likely cost you a substantial amount of money, which is one of the consequences of time decay. In other words, unless the underlying stock is dropping, there may be considerable costs to holding on to protective puts.

The strike price the put buyer chooses can make a difference. It affects the amount of time decay and overall protection the option provides. Put options with a lower strike price are cheaper to purchase but ultimately offer a lower degree of protection, particularly on smaller stock price moves. If the strike price is significantly lower than the current stock price, the rate of time decay is less. On the other hand, investors who want to maximize their protection may elect to buy a put option that's close to a stock's current price, but it could result in a more expensive option subject to a greater amount of time decay.

Now that we've covered how time decay could work against an option buyer, let's turn to volatility. Implied volatility in options contracts may or may not benefit the buyer. A drop in volatility can make profiting from a protective put more difficult, while an increase could potentially make it easier to profit. However, the potential for increased profitability could also lead to more expensive options prices. It might make sense to buy put options before a time of potentially high stock volatility like earnings, but options prices will accordingly be more expensive. After the uncertainty dies down, options prices also tend to fall because of the accompanying drop in implied volatility.

A protective put can make sense in a portfolio to help protect against a strong stock price drop. However, because of the associated costs of holding a put option, it's unlikely to be a permanent, repeating addition to a portfolio, where the investor constantly buys new puts each time the old puts expire. Instead, protective puts are generally used in a more targeted fashion. In other words, if there's a specific situation or time period that warrants this protection, a protective put may make sense for that particular circumstance. Once the situation has passed, the protective put can be removed.

If you're bearish on a particular stock, it may make the most sense to sell the stock until your outlook changes. Risk is part of the stock market, and you need to be mindful of your personal risk tolerance.