InvestorQ : What is a protective put option and when is it actually used?
Nishant Chandani made post

What is a protective put option and when is it actually used?

Answer
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Mary Joseph answered.
2 years ago


In a protective put the trader buys a cash market position and then protects the downside risk by attaching a put option. Here the trader continues to be positive on the stock but also wants to protect the downside risk by adding a put option. Assume that you bought SBI at Rs.280 and then decided to protect the position by attaching a 275 put option at a premium of Rs.5. Here is how the payoffs will look like.

Bought SBI in spot market at Rs.280 and bought Rs.275 put option at Rs.5

Option Strike

Stock Buy Price

Market Price

P/L Spot

Option ITM/OTM

Option Premium

P/L on option

Net Profit / loss

275

280

220

-60

ITM

-5

55

-10

275

280

225

-55

ITM

-5

50

-10

275

280

230

-50

ITM

-5

45

-10

275

280

235

-45

ITM

-5

40

-10

275

280

240

-40

ITM

-5

35

-10

275

280

245

-35

ITM

-5

30

-10

275

280

250

-30

ITM

-5

25

-10

275

280

255

-25

ITM

-5

20

-10

275

280

260

-20

ITM

-5

15

-10

275

280

265

-15

ITM

-5

10

-10

275

280

270

-10

ITM

-5

5

-10

275

280

275

-5

ATM

-5

0

-10

275

280

280

0

OTM

-5

0

-5

275

280

285

5

OTM

-5

0

0

275

280

290

10

OTM

-5

0

5

275

280

295

15

OTM

-5

0

10

275

280

300

20

OTM

-5

0

15

275

280

305

25

OTM

-5

0

20

275

280

310

30

OTM

-5

0

25

275

280

315

35

OTM

-5

0

30

275

280

320

40

OTM

-5

0

35

275

280

325

45

OTM

-5

0

40

275

280

330

50

OTM

-5

0

45

275

280

335

55

OTM

-5

0

50

275

280

340

60

OTM

-5

0

55

There are some interesting points that emerge from the above payoff table. Firstly, the maximum loss of the protective put position is restricted to Rs.10, however low the price of SBI may go. The loss of Rs.10 is made up of Rs.5 premium paid on the put, which is a sunk cost, and the difference of Rs.5 between the spot price purchase and the strike price of the put (280 – 275). That is because once the cost of Rs.10 is covered then whatever is lost on the stock is gained on the put option and the position becomes neutral from there on. However, on the upside, the position is profitable once the cresses Rs.285. At that point the purchase price of the stock at Rs.280 and the option premium of Rs.5 is fully covered. From that point upwards, the profits on the protective put position can be unlimited.