Hedging your portfolio with a protective put can help you sleep better at night
Although options are often thought of as "risky" investments, these vehicles can actually be used to safeguard your stock portfolio. While there are many different ways that traders can utilize options to lock in profits and/or minimize potential losses, buying protective -- or "married" -- puts is one of the more straightforward and user-friendly options hedging strategies.
A protective put acts like insurance for your investment. Just like homeowners are willing to pay an insurance premium to protect their homes from storms, many investors are willing to spend a little extra to protect their profits from a downturn, and a protective put is one way to do this. A protective put allows investors to lock in some gains on a stock they already own. When an investor is bullish in the long term, but fears a pullback in the near term, she can purchase a protective put to guarantee a minimum selling price, in case things take a turn for the worse.
For example, imagine you have 100 shares of Stock XYZ, which you purchased for $50 each, totaling a $5,000 investment. XYZ is now worth $100 per share, so your investment is now worth a whopping $10,000, leaving you with a 100% profit of $5,000. However, XYZ is set to release earnings soon, and while you're nervous, you don't necessarily want to unload your shares just yet and miss out on more potential upside.
Instead of selling your XYZ shares, you could purchase a protective put to ensure you're able to reap at least some profits, even if XYZ takes a nosedive. If you choose to purchase a 90-strike put on the shares for an ask price of 50 cents, or $50 (as each option covers 100 shares), even if the stock plummets to $75 after earnings -- and within the option's lifetime -- the put gives you the right to sell your shares for $90 apiece, or $9,000 total, leaving you with a $3,950 profit on your initial $5,000 investment, after subtracting the cost of the put option (and not including brokerage fees). Had you not bought options "insurance," your XYZ share gains would've dwindled by much more.
If the shares continue to rally, on the other hand, you'll be out the $50 used to purchase the put, but your portfolio gains will continue to bloom. So, as with most insurance policies, the protective put buyer isn't hoping for a disaster -- she just wants to sleep a little better at night.
Of course, a protective put can be combined with other hedging strategies to further protect investments, such as a
collar, but each of these moves comes with its own array of advantages and disadvantages and
may not be appropriate for all traders and situations.
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