Protective Put
Outlook: Long-term bullish, short-term nervous

A protective put (a.k.a. "married put") is used to hedge against losses on an existing stock position. This strategy is typically employed when the investor remains bullish on the long-term prospects for the company, and would ultimately like to keep the shares in his portfolio. However, due to the perceived risk of a decline or increased volatility over the near term, the trader will purchase a put option as a kind of insurance policy on his shares. By doing so, the shareholder has effectively locked in a minimum selling price for his stock throughout the lifetime of the options.

Entering the Trade

Let's say you have 100 shares of XYZ in your portfolio. You bought in at $35 per share for a total investment of $3,500. The stock has since advanced to $42.50, which means your stake is now worth $4,250. You're happy with your paper profit of $750, and you think there's more upside in store for XYZ over the long haul. That said, you're a little nervous that the company's upcoming earnings report may fall short of expectations, and you don't want to sit idly by while your unrealized gains vanish.

To hedge your XYZ stake, you could buy one 37.50-strike put option, currently asked at 0.50, for an upfront cost of $50 (ask price of 0.50 x 100 shares). As a put holder, you have now acquired the right to sell 100 shares of XYZ at no less than $37.50 per share, should the stock fall below that threshold prior to the option's expiration.

Potential Gains

Your "gains" on a protective put aren't entirely straightforward. Ultimately, as a shareholder, you'd like to see the stock keep rising -- even if that means your option expires worthless. In the ideal situation, XYZ would continue its ascent, and your eventual gains on the stock would more than offset the $50 you paid to acquire short-term put protection. As an investor, then, your potential upside is theoretically unlimited.

In this scenario, though, you can still eke out a profit even if the stock drops. That's because you purchased a protective put option at a strike price 2.5 points above where the shares were trading when you first bought them.

If XYZ should drop back to $35 by the time expiration rolls around, you can exercise your option to sell your 100 shares for $37.50 each. You bought in for $3,500, and then sold your shares for $3,750 -- resulting in a profit of $250 on the investment. Less the cost of your option, you came out $200 ahead. And if you hadn't picked up that protective put, you could have bid farewell to all of your paper profits.

Potential Losses

As with many option-buying strategies, your maximum potential loss on the protective put is limited to the amount you paid to buy the contract(s). This loss will be realized if XYZ settles at or above the strike price of the purchased put upon expiration. The good news here is that the stock is still faring well, and -- as a shareholder -- you're still poised to benefit from any additional upside.

Volatility Impact

When you buy a protective put on a stock you own, you're essentially long and short at the same time. As such, the impact of volatility on your overall position will be relatively muted.

Other Considerations

Depending upon your preference, the protective put can be customized in a number of different ways. Most notably, your strike selection can be tweaked higher or lower to accommodate your personal risk tolerance. While some investors prefer to lock in paper profits, others might be content to take their leave on a move back down to breakeven. Still others might be OK with swallowing a small loss on the shares. In any event, bear this in mind: deeper out-of-the-money puts will be cheaper to buy, but they'll afford you less protection on a downside move.