Preserving Profits with Protective Puts

It's a scenario familiar to virtually all veteran investors: a trader purchases a stock he suspects will make a large upside move in the near future ... and it does! Dreaming of even higher profits, the now elated investor decides to hold onto his shares for just a little bit longer, only to watch them crash. However, by utilizing options -- specifically, protective puts -- that trader could've "insured" his position to lock in gains.

For many people, the stress and anxiety involved with watching a stock portfolio fluctuate is the hardest part about investing in a market when timing is everything. But thankfully, protective puts allow you to counter sudden downturns and defend your investments -- and sleep a little easier at night.

By purchasing a put, a trader is granted the right to sell 100 shares (per contract) of a stock at a pre-determined strike price within a pre-determined period of time. (Click here for a tutorial on put options). "Vanilla" option traders will utilize put options to essentially "short" a stock, but these contracts can also be used to cover a long stock position.

Here is how it works. Let's say that a fictional investor named "Trey" has a feeling that stock XYZ is going to skyrocket over the next quarter, so he purchases 100 shares of the equity for $20 a piece -- a total investment of $2,000. In the coming months, solid earnings and news of a CEO replacement pushes XYZ up 50%, and Trey has made a cool $1,000 profit on his initial buy-in. Trey hopes XYZ will keep going up, but rather than risk losing his entire profit in the event of a downturn, Trey decides to buy a protective put to hedge his initial bet.

XYZ is currently trading at $30, so in order to protect his position, Trey decides to purchase a six-month 27-strike put for an ask price of $1. Options represent 100 underlying shares of equity, so total cost for the put is $100. Should XYZ fall below $27, Trey can either exercise the option to sell his shares at a premium to current trading levels -- and lock in gains on his initial investment -- or sell the put to close at a profit.

Let's break down some numbers. Let's say that after Trey purchases his protective put, shares of XYZ fall down to $25. Had Trey not purchased a protective 27-strike put, he would be looking at a 50% cut of his initial portfolio gain -- from $1,000 down to $500. But, by exercising his 27-strike put, Trey can sell his 100 shares for $27 apiece, or $2,700 total. After subtracting the initial $100 paid for the option, he pockets $600 -- a 20% premium to the "unprotected" scenario.

As with all types of insurance -- wherein the policy holder isn't hoping for a disaster -- the protective put buyer is guarding against the worst. His real objective remains for XYZ to continue its ascent. He's willing to forfeit the premium paid for the put in order to lock in paper profits (and subsequently reduce his anxiety levels).