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What is a Protective Put

What is Protective Put?

Investors use protective put, a risk-management technique based on options contracts. Its objective is to reduce possible losses that could arise from an unanticipated decline in the underlying asset/stock value. Investors who have shares in an organisation can purchase puts as a hedging strategy. 

This technique does not limit the chances of probable opportunities for an investor. On the contrary, the growth potential of the underlying asset governs the strategy's profits. The premium, though, takes a portion out of the profits.

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What is a premium?

The investor needs to pay a certain amount, i.e., a premium, to obtain the put options. With a premium, they can sell an underlying asset at a fixed strike price. There are different factors that can influence the premium. These include market conditions, volatility, expiration timeline, and the cost difference between the strike price and the original market value. 

What does strike price mean in this?

The strike price is the fixed amount at which an underlying asset can be sold while exercising the put option. This price is locked by an investor to limit losses in case the asset value decreases. Protective put greatly lies on the strike price and should be carefully studied. At the right price, an investor can generate a profit. Put options give the holder the right to sell shares as a choice without any contractual obligation.

Understanding with an example 

An investor holds 100 shares of ABC organisation, currently trading for Rs. 100 per share. Having doubts about potential negative market fluctuation, they invest in protective put options. With a strike price of Rs. 100 and a premium of Rs. 5 per share, they finalise the purchase. The protective put's compensation is based on the organisation’s future share value. Three possible scenarios might occur accordingly.

Share value above Rs. 100 

The investor will profit if the share price rises above Rs. 105. The current share price stands at Rs. 105 (initial share price + put premium). Here, the put isn’t implemented.

Share value between Rs. 100 and Rs. 105

The share price will either stay the same or witness a slight hike here. Even so, the investor will end up losing money in the form of the premium they paid. Here too, the put won’t be implemented.

Share value below Rs. 100

To minimise losses, an investor will implement the protective put. As a result, they will sell the 100 shares at Rs. 100 each. Here, the loss will be restricted to the premium the investor paid. 

When must an investor buy a protective put option contract?

Investors can purchase a protective put option contract whenever they want. Some investors purchase these together with their stock purchase. Others might hold off and purchase later. The link that develops between the asset cost and the strike price is called 'moneyness'. Henceforth, a contract undergoes three classifications :  

  1.  (ATM), where the asset cost and strike price are equal.
  2. Out-of-the-money (OTM), where the asset's cost exceeds the strike price.
  3. In-the-money (ITM), where the asset's cost is less than the strike price.

Investors wanting to protect their holdings from losses mostly concentrate on the ATM and OTM options.

To conclude

Investors willing to withhold their long positions in volatile markets use the protective put strategy. They can reduce potential losses and mitigate risk by buying put options. In the world of finance, the protective put provides security with careful evaluation of premiums and strike prices.

 

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