We all know not to invest money we can’t afford to lose.
At least, we all should know NOW.
However, succumbing to temptation is human and often when we have a long bull market such as the one we had until March of 2020, people start to think that this is going to last forever.
As a result, they over invest and don’t leave enough cash reserves in case things go south.
Inevitably, things do go south and when this happens, those who are over-invested are trapped.
Do they sell their stocks for cheap knowing they are getting a bad deal for them? Or do they hope their stocks stop dropping in value and will appreciate in time for when they need to cash them out?
A protective Put may provide an alternative for investors stuck in this situation.
Before you proceed however, I should mention that I do believe options are Haram (forbidden in Islam) when they are used to speculate on price. However, they are Halal (permissible in Islam) when used to hedge risk. For more of my thoughts on the topic, please read: Options: Halal or Haram?
Understanding Protective Puts
A protective put combines a put option with a long position in the stock.
A put option is a financial contract that gives its holder the right but not the obligation to sell their shares for a specific price on or before a specific date.
A long position in a stock simply means you own the stock and are hoping for it to appreciate in price.
Combining a put option with a long position in a particular stock means that you’ve essentially paid a fee (the value of the option contract) for someone else to bear some of the downside price risk of your stock holding.
Let’s look at an example to understand this better:
You own 100 shares in XYZ company, currently trading at $1,000 per share.
Bare with me, I know this may be really hard to imagine, but assume a pandemic breaks out and you’re concerned the price of XYZ may fall to below $700 per share.
You don’t want to set a stop loss at $700 since the price could recover quickly and you may not be able to reestablish your equity in XYZ.
Instead, you decide to purchase a put option with a strike price at $700 expiring in 90 days to protect your position.
This options gives you the right to sell your shares for $700 anytime in the next 90 days.
This means your 100 shares in XYZ are now protected from any drop in price below $700 for the next 90 days because in the event they do, you can always sell at $700.
In other words, your maximum loss per share of XYZ stock over the next 90 days is $1000 – $700 + the price of the put option
Your breakeven price per share (assuming you bought the shares for $1,000) is now $1,000 + the price of the put option
You maximum profit is technically unlimited since you still own the XYZ shares.
Basically, by using a protective put, you have offloaded some of the price risk you had unto the put’s seller in return for paying the price of the put.
Something to consider in times of panic and concern about your investment portfolio’s value.
Disclaimer: This is not investment advice. Make sure you do your own due diligence before making any investment decisions. The information in this article is for informational and educational purposes only.