Want to limit your downside risk? Introducing the protective put strategy

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When an option acts as insurance.

© Taras, Julie/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

Do you own stocks—or a portfolio of stocks—and you’re worried about a potential meltdown in the short term? Or are you a short-term trader looking to ride the upside, but you want to limit your downside risk?

In general, you have two choices. (Three, if you count selling out now and walking away—but let’s assume you’re not ready to bail, unless prices deteriorate.)

Which is better? As with most financial choices, there are trade-offs. With the long put option, you have the flexibility of choosing—right up to the last minute before expiration—whether you should exercise it. So if the stock falls below the strike price, but then shoots up higher, you get to keep your stock and hopefully watch as it rallies further. With a stop order, once it’s filled, you’re out, regardless of what happens to the stock price afterward.

Of course, there’s a price to pay for the option. It’s called a premium (just like the premiums you pay on home, auto, and life insurance). In exchange for the premium, you’ll get peace of mind knowing you have a fixed sell point ready at your discretion.

Suppose you own 100 shares of stock XYZ and it’s currently trading at $100 per share. You’ve watched it appreciate in value over the years, and you think it’s got a good chance to continue upward—but if it were to drift down over the next two months, you’re concerned it could lead to a free fall in the share price. You want to limit your downside risk with a long put. Here’s how you might do it:

With the protective put strategy, you have a hard line in the sand on your max risk point. That can give you comfort because you know your worst-case scenario in advance (see figure 1), no matter how much the share price plummets.

If the stock were to rally instead of fall, you’ll still own the shares, and the option would expire worthless. You’d lose that $2 premium per share, but the stock will be worth more than before.

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Figure 2: DOWNSIDE INSURANCE. With a protective put under your long stock, you still profit from a stock rally (minus the premium you paid for the option), but any downside losses are limited to the strike price plus the premium you paid. For educational purposes only. 

Encyclopædia Britannica, Inc.

Now that you’re familiar with the protective put strategy, let’s take it to the next level: Buying index puts to protect—to some degree—a portfolio of stocks.

Let’s say you have a buy-and-hold portfolio of stocks and they’ve rallied nicely over the last six months. You’d like to hang on to them for various reasons, but you’re concerned about a potential for a nasty downturn coming up. Depending on the makeup of stocks in your portfolio, you may be able to buy put option protection on an index that is highly correlated with your portfolio rather than buying put options on the individual stocks.

Suppose you own eight stocks in your portfolio. They’re all high-market-cap stocks with a very close correlation to the S&P 500 Index (SPX), and you’d like to protect your portfolio from a downside move of 5% or more. You could purchase put options on an ETF that tracks the SPX, such as the popular SPDR S&P 500 ETF (SPY).

ETF option contracts also control 100 shares of the underlying, so at a current price of $400, each SPY contract has a notional value of $40,000. If you wish to fully cover $200,000 worth of stocks that correlate to the S&P 500, you would need $200,000/$40,000="5" contracts of SPY.

You’d select a strike that’s 5% out of the money. So if SPY is trading at $400, you’d be looking at a strike price of 380. You pull up an option chain and see that the 90-day, 380-strike put is offered at $5.80.

This is a simplistic example. In real life, the stocks in your portfolio may have different volatility characteristics (beta) than the SPY. This could cause some drift in modeled returns as time goes by. Plus, you would likely liquidate your contracts before expiration, because the portfolio protection you received by buying the put option isn’t an exact match to your portfolio holdings. It’s an approximation of the risk profile.

In other words, you can’t exercise your SPY puts and match them up against your portfolio like you can with options on individual stocks.

In this example, you’ve fixed a max risk point for your portfolio (-5%) for a 1.45% insurance premium over a 90-day period. At the end of the 90 days, your portfolio will be unhedged again, and you’ll have to decide if you’d like to roll your protection for an extended time period of time or carry on with an unprotected portfolio. Or, on the upside, you might be completely wrong about a pending downturn. The market could rally by more than 1.45% over the next 90 days, covering the cost of your insurance.

What if instead of high-market-cap stocks that correlate to the S&P 500, you want to protect a portfolio of high-flying technology stocks, or blue-chip stocks? You could use another ETF, such as the Invesco QQQ Trust (QQQ) that tracks the Nasdaq-100 Index (NDX), or the SPDR Dow Jones Industrial Average ETF (DIA), which tracks the 30 stocks of the Dow. And, of course, if you’re looking to cover the risk in a basket of stocks in consumer discretionary, energy, or any other sector, subsector, or industry, there are indexes and ETFs that track those indexes.

Buying put options can be an alternative to the stop order as a targeted but flexible exit strategy. At its core, the protective put strategy is insurance, plain and simple. And just as with car or home insurance, there’s a premium attached.

That premium is the cost of peace of mind in a worst-case scenario. It’s up to you to decide when and where it’s needed. And remember: We’ve just covered the basics here. For each stock and ETF, there are several expiration dates, and for each one there are dozens—sometimes hundreds—of listed strike prices. Strike selection is a blend of art and science that requires patience and experimentation.