Protective puts

In short

A friend of mine once bought homeowner's insurance the week before a storm, and he slept better for it, though the storm never came. A protective put works about the same way. You own shares of a stock, and you buy a put option on those same shares. The put gives you the right to sell at a set price, called the strike, until a set date. If the stock falls below your strike, that right limits your loss. If the stock rises, you keep the gain, minus what you paid for the put. The price of that peace of mind is the premium, and it is gone whether or not you need the protection. Before you place any trade, check the cost against the number of shares you hold. Know the date the put expires, and know what you plan to do when it does.

The whole of it

What it is

I once watched a neighbor lock his barn every night, though nobody in our county had lost a horse in years. When I asked him why, he smiled and said the lock cost him less than the worry. A protective put is that kind of lock, and you are the one who decides how strong to make it.

Here is the plain picture. An option is a contract. A put option is a contract that lets its owner sell 100 shares of a stock at the strike price, any time up to the expiration date. That is the right, not the duty. You pay a fee for the contract, called the premium. You quote it per share, so a premium of 2 dollars means 200 dollars for one contract.

Now put the two pieces side by side. You hold the stock. You also hold the put. Together they are a protective put, which some folks call a married put when both are bought at the same time. Your stock can climb as high as the market takes it. Your downside has a floor, though the floor sits a little lower than your strike, because of the premium you paid.

How it works

You have probably felt that small knot in your stomach when a stock you own drops hard in a single week. The protective put is built for that feeling. Let me walk you through it slowly.

Say you hold 100 shares and you buy one put contract. If the stock ends up above the strike when the contract expires, the put is worth nothing. It simply expires. You lose the premium and keep your shares, which are worth more than before. If the stock ends up below the strike, the put gains value dollar for dollar as the stock slides under the strike. That gain offsets the loss on your shares. You may sell the put for its value, or use it to sell your shares at the strike.

A few terms help here. A put that is in the money has a strike above the current stock price. A put that is out of the money has a strike below it. A higher strike gives more protection and costs more. A lower strike costs less but lets you absorb more of a drop first. The distance from today's price to your strike is a loss you agree to carry yourself, much like a deductible on a car policy.

Time matters too. A put with more months left costs more, because there is more time for something to go wrong. Expected swings in the stock also raise the price. The market calls that implied volatility, which is just the size of the price swings the market expects. When people are nervous, puts get dearer, right when you most want one.

One more point. Most listed stock options in the United States can be exercised any time before expiration. Your broker can tell you how your account handles that, and what happens if you do nothing on the last day.

The numbers, and where to find yours

You may be wondering where the real figures live. Good news. Nearly everything you need is on your own screen, and the rest comes from a few plain sources.

The premium, the strike choices, and the expiration dates appear on the option chain in your brokerage account. An option chain is just a table listing every available contract for a stock. Look at the ask price, which is what you would pay. Check the bid too, because the gap between bid and ask is a hidden cost. Your broker also charges a commission per contract in some cases, and the fee schedule is posted on its website.

Tax is the part people skip. The IRS explains how options are taxed in Publication 550, Investment Income and Expenses. Buying a put against stock you already own can affect how long your shares count as held, which matters for the long term capital gains rate. The holding period rules for these positions are written out in that publication, and a tax professional can apply them to your case. The long term capital gains rate brackets change by year, so use the current figure, which the official source publishes each year for the current ones.

For how options work in general, the Options Clearing Corporation publishes a booklet called Characteristics and Risks of Standardized Options. Your broker must give it to you before you trade options. Read it. It is free, and it is the official word.

A worked example

Let me tell you about a woman named Maria. She owns 100 shares of a company, and each share trades at 50 dollars. Her position is worth 5,000 dollars. She has a big expense coming in three months and does not want to see that money shrink.

She looks at the option chain and finds a put with a strike of 45 dollars, expiring in three months. The premium is 2 dollars per share. She buys one contract. The cost is 2 dollars times 100 shares, which is 200 dollars.

Now watch three outcomes. First, the stock rises to 60 dollars. Her shares are worth 6,000 dollars. The put expires with no value. She gained 1,000 dollars on the shares and spent 200 dollars on the put, so her net gain is 800 dollars. Second, the stock stays at 50 dollars. The put expires with no value. She is out the 200 dollars and nothing more. Third, the stock falls to 35 dollars. Her shares are worth 3,500 dollars, a loss of 1,500 dollars. But her put lets her sell at 45 dollars. That put is worth 45 minus 35, which is 10 dollars per share, or 1,000 dollars. Her net result is the 1,500 dollar loss, less the 1,000 dollar put gain, plus the 200 dollar premium. That is 1,500 minus 1,000 plus 200, or a total loss of 700 dollars.

Compare that to owning the shares alone, which would have cost her 1,500 dollars. Her worst case with the put is the 500 dollar drop from 50 down to the 45 dollar strike, plus the 200 dollar premium. Five hundred plus 200 is 700 dollars. No matter how far the stock falls, her loss stops there.

That is the whole bargain. She paid 200 dollars to cap her loss at 700 dollars. It was her choice, and a sensible one for her situation.

Where it goes wrong

I have seen good people stumble on this, and it was never for lack of smarts. It was lack of a plain warning. So here are the soft spots.

The premium is a sure cost. If you buy a put every three months, those fees add up. Over a year of four 200 dollar puts, you would spend 800 dollars on a 5,000 dollar position. That is a real drag on what you keep.

Timing can trip you. If the stock drops, but only after your put expires, the protection was gone when you needed it. Protection only covers the period you paid for.

Sizing errors happen. One contract covers 100 shares. If you own 150 shares, one contract leaves 50 unprotected. Count carefully.

Wide bid and ask gaps eat money on thinly traded options. Check them before you buy.

Last, the put does not stop the stock from falling. It only softens what you lose. You still own a stock that went down. Also, options carry their own risks and are not right for every account. Your broker may need to approve you for options trading first.

Questions to answer before you leave this page

How many shares do I own, and does that number divide neatly into groups of 100? What is the most I am willing to lose on this position, and does the strike I am looking at match that number? Have I added up the premium, any commission, and the bid and ask gap to see my true cost? Do I know the exact expiration date, and what will I do on that day? Have I read the Characteristics and Risks of Standardized Options booklet from the Options Clearing Corporation? Do I understand how Publication 550 treats this trade for my taxes, or have I asked someone who does? And finally, am I buying this protection because it fits my plan, or because I felt a jolt of fear this morning?