Stock Decline Protective Put

Note: Protective put is also known as married put. Last year I had written an article on married put, but I think it was not well explained. So I am writing it again in details with more explanation and examples.

How many times has it happened that you bought a stock and it moved up, remained there for some time and then came crashing down before you could even book profits. You were not in a mood to book profits, thinking that the rally isn’t over. But exactly opposite happened. Sorry if it has happened to you. But the fact is you should have booked profits or bought a protective put.

What is a protective put?

If you buy a stock/future and the stock rallies, you are making a good profit. But this profit is just on paper as you got to sell the stock to book profits. However you are certain that the rally isn’t over yet and you do not want to sell the stock. In that case what can you do? If you sell the stock, any further rally has no meaning for you as you are out of the trade. You booked your profits and you are out.

In such a situation where you want to participate in further rally and make sure the profits made so far are not lost, you can buy an ATM (at the money) put. Now your profits are locked. How?

Example:

Lets suppose you bought ICICI bank stock when it was at 1000. The stock rallied and reached 1100. You are sitting at 10% profits. But its election time and you are sure the stock may rally 10-15% more. But anything can happen in the stock markets. To make sure you do not lose what you have already made, you but an ATM put. Since the stock is rallying, the puts will not be costly. Why? Because market players will pay more to buy calls as the stock is moving north. Who will pay more for puts when everyone knows that the stock is moving up?

Please note that if volatility is high, both the calls and the puts will be costly irrespective of the direction of the stock. This is done deliberately by the market makers to make sure there are no arbitrage opportunities. Can’t explain this in details. But just in short – if the puts were very cheap compared to calls – market arbitragers will buy both the calls and puts and make money if the stock moves in any direction fast. So why is this a problem for the markets? All professional traders will become arbitragers. The sellers will lose for certain. Markets should be a place giving equal opportunities to everyone. Arbitrage opportunities are not good. If every time arbitragers win, you and I will leave trading or join the arbitrage group. If there is no other group, there will be no trading.

If you now buy a ATM put, your profits are protected. However nothing comes for free. To play the up-move that may or may not happen, you got to pay a price. This price is the price you pay for the puts. Depending on volatility the price of ATM put of the current month may be 3-4% of the profits you are making. So it could be 30-40 odd points. Remember your profits are 100 points. Therefore if you think there is a 10% move still left and you want to play for that move, you have to pay 3-4% of what you have already made to protect your profits.

Now if the stock moves up, you will make money from the long shares/futures, but you will lose money in the put you bought.

If ICICI bank actually moves up 10% more to 1210, you can book your profits. Your profits will be the profits minus the price you paid to buy the puts. Remember if the stock goes up and finishes above the put strike price, the put will expire worthless. You will get nothing when you sell the put.

Of course if you think the rally is still not over, you may have to buy the next month’s ATM put. This depends on your view of the stock. However there is a saying in English – don’t push your luck. For traders its advisable that you book your profits and look for opportunities elsewhere. A 20% fast move is rare. Book your profits, don’t be greedy.

Still you can keep doing this till the rally is over. The only problem is that your profits will be reduced by the money you paid to buy the puts.

However there will be time when the stock will not move any further and slide down. The protective put will now do its job. How?

Lets take an example.

Step 1) You bought a stock at 1000.

Step 2) The stock rallies to 1100. You are confident the stock will move up even more.

Step 3) You buy a protective at the money (ATM) put at strike of 1100 by paying for 30 points.

Step 4) You were wrong. There was bad news in the company and the stock starts to come down. You are least bothered because you have bought the protective put.

Step 5) By the end of the month the stock reaches 900. 10% lower than your buy price.

Step 6) You close both the positions. You are in profits.

Calculations:

Loss in the stock 900 – 1000 = -100 * 250 = -25000.

Profit in the protective put: The 1100 put will be at 200 (1100 – 900).
The profits = (200 – 30) * 250 = 42500.

Total profits = 42500 – 25000 = 17,500.

In fact your profits are protected wherever the stock closes. Anywhere below the strike price of the put, you will make a profit of 17,500.

Now this isn’t over yet. What happens if the stock keeps rallying?

What happens if the stocks moves up and you want to book the profits at 1200? You will make even more money.

How?

Calculations:

Profit from the stock 1200 – 1000 = 200 * 250 = 50,000

Loss from the put: The put expires worthless. The cost of the put = 30 * 250 = 7500

Total profits: 50000 – 7500 = 42,500.

You will make more if the stock keeps rallying.

Isn’t the protective put a great option? Yes it is. It protected your profits and it also allows you to play the rally without worrying about the stock going down.

Important point: You know what the professionals do? They buy the protective put as soon as they buy the stock. Yes they are willing to pay a price to make sure they are not stuck at a stock if there is a huge decline. Overnight the stock may open in a huge gap down. In that case the put will make money and they can get out of the stock at a small loss.

Therefore hedging is important whenever you trade.

But remember protective put comes at a cost. So if you are long term investor and want to hold the stock for a long time, the protective put is not required. Since you are holding the stock and willing to wait to reach your target price – buying a put will be of no help. When trading everything has a purpose and we trade with a logic.

Buying a protective put for long term traders has no logic and does not solve any purpose. Yes suddenly one day if the stock jumps and you want to protect your profits – a protective put will be of help.

But if trading a stock for the short term (not intraday) – a protective put is a great trade to protect your profits.

Why not intraday? Because traders playing intraday have a stop loss in the system already and if the stock reaches that point the stop-loss gets violated and trade stops. What does a protective put do here? Nothing.

For intraday trading the best hedge is to sell calls if buying, and sell puts if selling the stock. Protective put will be of little help here as the Intraday traders book profits or losses in small movement of the stock. Protective put is meant to protect your money if the stock moves down substantially.

For positional positions short-term, if you have bought a future or equivalent value of stock, a protective put will be of great help if the stock declines.

Smart traders will actually put a stop loss to the put if they see there is no chance the stock will reverse direction if it is moving north. That way they reduce their losses from the put. But this can be risky.

I usually do not get out of the put until I get out of the stock itself. I therefore do not recommend a stop loss in the puts. Sell put when you sell the stock. I am a conservative trader and I love to remain that way.

Some people might think why a trader does not lose money if they buy the put and the stock rallies. That is because the put does not shrink in value the way the stock increases in value.

Put will not reach a worthless figure before the last trading day (probably hour). It will retain some value until the last hour of the last trading session of the month even if the stock has rallied a lot.

I hope its clear what’s the actual job of a protective put. Its strange how most traders in India feel its a waste of money to buy protective puts, until one day they see their stock crashing.

Have you ever bought a protective put? If yes, has it helped?

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