Protective Puts: Insuring Your Portfolio Against Market Drops
Introduction
Worried about a market crash wiping out your stock gains? A protective put acts like insurance, limiting losses while keeping your upside potential. In this post, we’ll cover how protective puts work, when to use them, and their pros and cons, with a practical example to show their value.
How Protective Puts Work
You own a stock and buy a put option, giving you the right to sell at a set strike price. If the stock plummets, the put’s value rises, offsetting losses below the strike. You pay a premium for this protection, like an insurance policy you hope not to use.
When to Use It
Use protective puts when you’re bullish long-term but fear short-term drops, such as before earnings or in volatile markets. They’re great for protecting gains on appreciated stocks without selling, avoiding tax events.
Real-World Scenario
You own 200 Tesla shares at $200 ($40,000 total). Fearing an earnings miss, you buy two $180 puts for $5 each ($1,000 total). If Tesla drops to $150, the puts let you sell at $180, saving $30/share minus the $5 premium ($25/share net). If Tesla rises to $250, you lose the $5 premium but gain $45/share on the stock.
Risks and Rewards
- Reward: Unlimited upside (minus premium), as you keep the stock’s gains.
- Risk: Limited to stock price minus strike plus premium. The premium reduces returns if no drop occurs.
- Pros: Caps downside, retains upside, provides peace of mind.
- Cons: Premiums are costly, especially for volatile stocks; small drops may worsen losses due to premium costs.
Conclusion
Protective puts offer a safety net for your portfolio, ideal for turbulent times or key holdings. While premiums add cost, the protection can be worth it for significant risks. Our next post will tackle advanced strategies like straddles and condors!
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