Protective Put – Hedging Of Equity Positions

A protective put allows equity investors to use options or warrants to hedge against a stock’s price slump in the short term. To do this, a put option or put option for the share in the investor’s portfolio must be purchased, the price of which is to be hedged. Simply explained: This option strategy has the effect that the equity investor can profit from a possible fall in the share price to the same extent as the fall in value of the actual share in the portfolio is reflected in the purchase of the put option.

However, an option premium must be paid for the protective put, so that in practice there is no break even but a (small) loss.

Advantage of a protective put strategy:

  • Protection against falling share prices in the portfolio
  • strong instrument in risk management for equity investments

Disadvantage of a protective put strategy:

  • there is a premium to be paid for the purchase of the put option
  • the option premium increases the closer the put option is to the money and with increasing remaining term

Example of loss limitation of a stock investment with a protective put

Let us assume that one share has a price of 102 € today. There are 200 shares of the company in the portfolio. The share owner and investor expects the share price to fall in the next few weeks and would like to hedge the price with a value of 102 € as well.

Ideally, the investor therefore buys two put options for 100 shares each with an exercise price of 102 €. The term is for example 2 months. For this, an option premium of 2.00 per share, i.e. a total of € 400, must be paid per share.

If the share price falls to € 95 within the agreed option term of two months, for example, each share loses € 7 in value. In total, the price loss is therefore €1,400 in the portfolio. Instead of €20,400, the portfolio is now only worth €19,000. By buying the opposite put option, the investor can earn €1,400.

He could sell the shares via the put option at €20,400, although they are only worth €19,000 at the time the option is exercised. He has thus succeeded in creating a perfect “hedge” with the Protective Put. Were it not for the option premium of €400 paid in advance. This hampers him the bill. The paid option price therefore represents a loss.

However, the loss from the option premium is still much smaller than if he had to accept the actual loss in value for the shares without a protective put. The option premium is of course also included in the calculation if the share price stagnates or even rises contrary to original expectations and the put option is therefore not exercised.

What has to be taken into account in practice?

It must also be taken into account that the further the option is already at the money, the higher the option premium to be paid for the protective put. The calculation shown in the example can therefore turn out considerably more negative in practice.

Which factors determine the amount of the premium for the protective put?

There are two main factors that determine the level of the option premium for the protective put. Since a certain share price is to be hedged, the difference between the share price and exercise price prevailing on the market and the term are of decisive importance.

Difference between exercise price and share price

The further the Protective Put is on or in the money, the more expensive it is. If the risk of a price decline is estimated to be rather low, it may be worthwhile to choose a rather lower exercise price. The option premium to be paid is thus lower. In expectation of sharply falling prices, i.e. a high risk, the exercise price should be closer to the price to be hedged. The option premium to be paid is thus all the higher.

It is basically the same as with a private health insurance. If there are already indications that the state of health could deteriorate, a higher insurance premium must also be paid.

Term and implied volatility

The term of the option and the implied volatility associated with it also cause the price to rise. For this reason, protective puts are generally only concluded for short terms of one to three months. The longer the term chosen, the more expensive the option normally becomes.

However, there is no linear relationship. Rather, the implied volatility seen in the share must be taken into account. If market participants expect considerable fluctuations in the price of the underlying asset during the term of the option, there is also an increased risk of a downward swing and thus has an impact on the option price.

With a longer maturity, the probability increases that market changes will cause fluctuations in the share price. The implicit volatility and thus the price of the protective put is therefore all the higher.

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