How Protective Puts Act as Insurance for Your Portfolio

In recent weeks, Schaeffer's Senior V.P. of Research Todd Salamone has been discussing the risk of a volatility spike, as the CBOE Volatility Index (VIX) has been in a sideways pattern since sinking post-election. As such, with equities rallying to record highs, Salamone has suggested using options to limit volatility risks. Last week we discussed how to use a stock replacement strategy to limit downside risk, but today we're discussing the use of protective puts as a hedge for long stock positions.

What is a Protective Put?

Using protective puts is fairly straightforward. Let's say you own 100 shares of stock XYZ, which you bought last year at $10 each -- $1,000 total. The stock has been rallying alongside the broad market in recent months, providing healthy returns, and XYZ is now worth $20. If you sold now, you'd have made a profit of 100%, or $1,000. On one hand, you're nervous a sudden volatility pop could send the market reeling, and XYZ will lose value. On the other hand, it looks like the stock could still have room to run, and you don't want to miss out on potential gains. Besides, a volatility spike could potentially see stocks making big moves in either direction.

So instead of selling the stock, you could hold on to your long position and purchase puts on XYZ to protect yourself against a surprise downside move. To do so, you buy 1 17-strike put for 50 cents, which expires in two months. With 100 shares per contract, the put will cost you a total outlay of $50.

How Does a Protective Put Limit Risk?

Imagine XYZ shares make a sudden move lower. The company has reported disappointing earnings, and now the shares are down to $15. The bad news is the profit on your stock has now been cut in half, to $500. The good news is that you bought protective puts.

You could exercise the put and sell your XYZ shares for $17 apiece -- $1,700 total, which represents a premium to "Street value." Or you could sell to close the put, which is now 2 points in the money, or worth at least $2 -- that's $200 total, or $150 after subtracting the initial premium paid. In this situation, you could hold on to your XYZ shares, if you think they could recover.

And if XYZ stock keeps rallying through the put's lifetime, you will simply continue to make profits. The protective put will expire worthless, but you're only out the initial $50 premium paid. With 100 shares, and stock XYZ rallying upward from $20, it will take only a 2.5% move higher in the shares to make that money back.

A Real Life Example

Bank stock Citigroup Inc (NYSE:C) has been on a tear since Election Day, adding 22% to trade at $60.63. The shares' most recent pullback found a floor at the $56 mark, but should that support fail to hold on another move lower, C could plummet back to pre-election levels. Perhaps that's why some recent options traders have been buying to open the June 45 put. Today that put is asked at 14 cents, meaning a single contract would cost the buyer $14.

Of course, it's not necessary to buy puts so far out of the money. But keep in mind, the closer an option is to being in the money, the more that option will cost. Time value plays a notable role in options pricing, too. Buying a protective put that doesn't expire for several months will cost more than buying a put set to expire in a few weeks, but it will also keep you protected for a longer period of time, without incurring further brokerage fees.