Protective Put

Components

Long the underlying asset and long put options.

Risk / Reward

Maximum Loss: Limited to the premium paid for the put option.

Maximum Gain: Unlimited as the market rallies.

Characteristics

When to use: When you are long stock and want to protect yourself against a market correction.

A Protective Put strategy has a very similar pay off profile to the Long Call. You maximum loss is limited to the premium paid for the option and you have an unlimited profit potential.

Protective Puts are ideal for investors whom are very risk averse, i.e. they hold stock and are concerned about a stock market correction. So, if the market does sell off rapidly, the value of the put options that the trader holds will increase while the value of the stock will decrease. If the combined position is hedged then the profits of the put options will offset the losses of the stock and all the investor will loose will be the premium paid.

However, if the market rises substantially past the exercise price of the put options, then the puts will expire worthless while the stock position increases. But, the loss of the put position is limited, while the profits gained from the increase in the stock position are unlimited. So, in this case the losses of the put option and the gains form the stock do not offset each other: the profits gained from the increase in the underlying out weight the loss sustained from the put option premium.