A protective put trade with options can be used to protect the value of a stock investment against an sudden drop in share price. The protective put can be used in place of a stop-loss order, providing more flexibility than the on/off characteristics of a stop-loss. Using a protective put requires an investor to already own the stock to be protected. If the stock is purchased at the same time the put trade is initiated, the trade or position is called a synthetic call.
1. Confirm you brokerage account has option trading privileges. The ability to buy and sell put and call options requires additional approvals on a stock market account. To add options trading authority, contact your brokerage firm for the application and disclosure paperwork. Approval for option trading usually takes a couple of days.
2. Select a put option to provide the protection against your stock falling in price. Options are defined by a strike price -- the price at which the option can be exercised -- and an expiration date. Expirations are listed by month and the exact date is the third Friday of the expiration month. An appropriate strike price is just below the current share price of the stock. For example, if Microsoft is currently at $24.75 per share, a put option with a strike price of $24 or $23 could be selected. For the example, we will use a put with two months to expiration.
3. Place a trade using your brokers option trading screen to buy one of the selected put options for each 100 shares of the underlying stock you own. In the example, if you own 500 shares of Microsoft, you could buy five Microsoft put options with a strike price of $23 and an expiration in two months. The cost of an option is the price times 100. The Microsoft put is quoted at $0.75. One contract would be $75 and five will cost $375 plus commissions.
4. Monitor the price of your stock shares and the value of the put options. If the stock price drops below the put option strike price, the puts will start to gain value. With a stock price below the put strike price you have three options: Sell the put options to lock in the profit due to the declining stock price. You will still own the stock and have made some money on the options. Exercise the put options. If you exercise, the seller of the options must buy your shares at the strike price. In the example, if Microsoft drops to $10 per share, you could exercise the options and receive the $23 strike price for your shares. Wait for the expiration date. If the stock price remains below the put strike price, the options will be automatically exercised. You will receive $23 per share and your shares will go to the option seller.
- A put option with a lower strike price will cost less money. However, a lower strike provides less protection against a share price drop.
- If the stock price is above the put option strike price at expiration, the option will expire without value. Think of the premium paid for the puts as insurance against a falling stock price.
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