Portfolio Insurance: Protective Puts

I wanted to discuss how options can be used as insurance policies for your portfolio.

If you want to preserve your wealth you can purchase what’s called a Protective Put Option.

What is a protective put option?

A protective put is a risk-management strategy using options contracts that investors employ to guard against the loss of owning a stock or asset. The hedging strategy involves an investor buying a put option for a fee, called a premium.

The only requirement here is that you own the actual stock that you’re buying puts on.

Example of a Protective Put Option

Each option contract is worth 100 shares of the underlying stock. If you own 100 shares of a stock, you can buy 1 put option for a fee (premium) at a strike $100 strike price (near-the-money). At that point, if the stock price drops you’ll be 100% protected and will be subject to a loss not exceeding the premium paid for the option contract. In this case, it would be a total of $500. If the share price goes up, you forfeit some potential gains because you paid a premium to protect your portfolio.

Why is this cool? If a quality stock drops 20% that you’ve protected, you can sell your insurance contract on the open market for a handsome profit and then buy more shares with those profits of the underlying stock at a discount. If the stock goes back up to where it was before, you actually own more shares of it now so you’ve juiced your returns essentially for free.

The main reason you’d want to employ this strategy is if you think the value of your stock or portfolio will go down in the near future. It carries a limited risk of loss and provides a great protective property to limit a potential loss.