Protective puts are one way traders can limit losses
Earnings season is in full swing, with several blue chips set to report this week. When trading options amid the volatility surrounding earnings, one way to mitigate risk is with protective puts.
How Protective Puts Work
One way traders can "insure" their investment and limit losses in the event of a major move lower is through protective puts. A protective put locks in a selling price (the strike) for the shares, just in case they take a turn for the worse.
For instance, let's say you bought 100 shares of Stock XYZ at $100 apiece, and they're now trading at $120. However, with earnings around the corner, you're scared the stock may give up some or all of those gains -- but you don't want to sell the shares just yet and miss out on additional upside. You could purchase a 110-strike protective put that encompasses the earnings release. That way, if XYZ tumbles back to the century mark after earnings, the protective put allows you to unload your shares at $110 -- locking in a 10% profit (minus the cost of the puts).
As such, the main goal of a protective put buyer is quite different than that of a “vanilla” put buyer. A protective put buyer is simply using the option as a form of insurance if the stock tanks; the trader's ultimate goal is for the shares to move higher -- and ideally offset the cost of the option -- leaving the put to expire worthless. A "vanilla" put buyer is actively looking for the underlying shares to fall.
Risk Assessment
While the protective put buyer's goal is to forfeit the initial premium paid for the put -- which represents the maximum risk on the trade -- you don't want to overpay. Against this backdrop, it's important to select the right strike and options series to accommodate your personal risk tolerance.
It is also important to be aware of the risks when trading options ahead of big events such as earnings. When a company has a planned event like earnings on the horizon, options premiums tend to be inflated. As a result, deeper out-of-the-money puts will be more affordable to purchase, but will allow less protection in the end.
In addition, the cost of the protective puts depends on time value. A 110-strike put that expires in two weeks will cost less than a put at the same strike expiring in two months, as the latter allows more time for the underlying stock to make a big move.