Protective Puts
A protective put is used when a trader is bullish on a stock he is buying or already owns, but is wary of the stock’s short-term future. It is used as a means to protect unrealized gains, while giving the trader continued upside potential.
For example, theoretically I want to buy 100 shares of Apple (AAPL) at 181. This is how I would implement the strategy.
First, I would buy my 100 shares.
Second, I would Buy to Open one AAPL January 180 Put for $5.50.
The total cash outlay for the put is actually $550 because each put represents 100 shares. That $550 is the insurance policy I took out on my stock position, and will protect my 100 shares if AAPL were to take a much bigger fall. Here’s a graph of the stock position combined with the put purchased:
In essence, I have bought an insurance policy that will protect me for two months from a big fall.
If AAPL falls, my losses are stopped at 180, which is the strike price of the put that I bought.
At 180 or below, I have the right, but not obligation, to exercise my put, which would take me out of my AAPL stock position. I would likely exercise this right to sell my stock at 180 if AAPL had fallen precipitously lower.
However, to the upside, my potential gains are unlimited!
While I don’t love paying for insurance/puts, given the recent dramatic drop in AAPL and countless other market leaders, this strategy is a great way to protect my stock holding while maintaining upside potential.