Case study: using protective puts to manage risk

Introduction:

In the realm of investing, protecting your portfolio against significant declines is crucial, especially during volatile market periods. One effective strategy to safeguard investments is through the use of protective puts. A protective put involves owning a stock and purchasing a put option on the same stock. This strategy acts as an insurance policy, allowing the investor to sell the stock at a predetermined price (strike price), thus limiting potential losses. While this approach requires paying a premium for the put option, it provides peace of mind and financial protection against downside risk. Protective puts are ideal for investors who want to maintain their stock positions while mitigating the risk of substantial declines.

Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.

Background:

Mike, a cautious investor, owns 300 shares of Fictitious Inc., an imaginary company created for the purpose of this case study. Fictitious Inc. is currently trading at $100 per share. Mike has been investing in Fictitious Inc. for several years and believes in its long-term growth potential. However, he is increasingly concerned about the possibility of market downturns that could erode the value of his investment. Mike prefers to hold onto his shares for long-term appreciation but is looking for a way to protect his investment from significant short-term losses.

Challenge: 

Mike wants to protect his investment from significant losses in case the stock price drops, without having to sell his shares. He is particularly worried about the market's short-term volatility and the potential impact of unexpected negative events on the stock price. Mike's goal is to find a strategy that provides a safety net against substantial declines while allowing him to continue benefiting from any future gains in the stock's value. He needs a solution that offers this protection without requiring him to constantly monitor the market or make frequent trading decisions.

Solution: Using Protective Puts:

To address his concerns, Mike decides to buy 3 put options on Fictitious Inc. with a strike price of $90, expiring in 60 days. Each put option provides Mike with the right to sell 100 shares of Fictitious Inc. at $90 per share, regardless of how low the market price drops. To acquire this protection, Mike pays a premium of $2 per share, totaling $600 for the 300 shares he owns. This investment in put options serves as an insurance policy against a significant drop in the stock price, ensuring that Mike can limit his losses while still participating in any potential upside.

Financial Comparison:

• Current Holdings: 300 shares of Fictitious Inc. at $100 each, totaling $30,000.
• Put Option Purchase: Premium paid: $2 per share; Total cost: $600.

Outcome and Analysis:

• If Fictitious Inc. trades at $100 at expiration:
  • Mike retains his shares and the put options expire worthless. His total cost is the $600 premium.
• If Fictitious Inc. trades at $80 at expiration:
  • Mike exercises his put options, selling his shares at the $90 strike price. His effective sale price, considering the premium, is $88 per share. This limits his loss to $3,600 ($12 loss per share on 300 shares, minus the premium paid).
• If Fictitious Inc. trades above $100 at expiration:
  • Mike retains his shares, and the put options expire worthless. He loses the $600 premium but benefits from any stock price appreciation beyond $100.

ROI and Yield:

• Cost of Protection: The $600 premium for 60 days translates to an annualized cost of approximately 12% ($600 / $30,000 * 6).
• Protection Against Downside: The protective put ensures that Mike can sell his shares at $90, limiting his downside risk significantly.

Conclusion:

By using protective puts, Mike secures his investment against significant declines while maintaining the potential for long-term growth. This strategy provides a safety net, allowing him to stay invested in Fictitious Inc. without the constant worry of a market downturn. Although it requires paying a premium, the protective put is a small price for the peace of mind and financial security it offers. This makes it an invaluable tool for risk-averse investors looking to protect their portfolios.