Construction: Buy 100 shares of stock, buy one put.
Function: To provide downside protection for a long stock position. It’s like owning shares of stock with an insurance policy to limit losses.
Bias: Bullish but cautious.
When to Use: When wishing to protect profits of a long-term stock position. You can also use it to protect speculative stock purchases such as buying potential technical breakouts, earnings, or other specific events that may cause large decreases in the stock’s price.
Breakeven: Your breakeven point is the stock purchase price plus the put premium.
Max Gain: Gains are realized if the stock price rises above the breakeven point. Because you own the shares, there’s no limit on how much you can make. Your upside profits are just reduced by the amount of the price purchased for the put.
Max Loss: Losses are realized if the stock price falls below the breakeven point. The maximum loss occurs at the put’s strike price. If the stock price falls to that strike or lower, you’ll face a fixed loss. The maximum loss equals the total price paid for the stock plus the put premium, less the put strike price.
Key Concepts: Due to the creation of time decay from the long put, the position is best used for protection of existing profits, or when a potentially aggressive or explosive upside move in the near future is a good possibility. The Protective Put is mathematically the opposite trade of the Sell-Write position.
Example: Buy 100 shares of stock for $50 per share, and buy one $45 put for $2. By purchasing the put, you have the right to sell your shares for the $45 strike. Because you paid $2 for the put, your breakeven price is $52. If the stock price falls below the $45 put at expiration, you can exercise the put and sell your shares for the $45 strike. Your total loss would therefore be $52 – $45, or $7. You could also choose hold on to your shares, but sell the put for cash, which offsets the loss in your long stock position.