Buying Protective Puts to help protect your investments from a loss

    Buying protective puts is a useful strategy when you are trading in the stock market.  When the markets start to get volatile many traders will buy puts to protect them from any downward movement their stock might make.  It is really a very simple strategy to learn and use. 

    If you want to understand how a protective put works you must first understand what a put option is.   A put gives you the right to sell a stock at a given price on or before a given day.  To get this right you will have to pay a small fee.

     If you buy the $50 DEC put for stock ABC you can sell ABC for $50 on or before the 3rd Friday of December.  This is true even if ABC is trading far below $50 by that day.

     Now how can you apply puts to protect you from the downside?  Let me show you.  Let us say you own a stock.  It is currently trading at $83. The market has been volatile lately and you are afraid that your stock might go lower.  You want to protect the profits you have made in it.

    One thing you could do is buy the $80 put options for your stock.  This would cost you maybe $1 per share.  Now if the stock goes down to say $71 you are protected.  Because you bought the $80 put you have the option to sell your stock for $80, even though it is only worth $71.  You would take just a small loss of $3+$1=$3, as opposed to a larger loss of $12.

    The disadvantage to buying protective puts is you could waste money.  If your stock went up or stayed at the same price then you would have lost $1. Your put just expired worthless.  Some traders see this as buying insurance, just like you would buy insurance on your house or car.  If they need it then that’s great, if they don’t oh well.

   Others will try to make up the cost of the put by selling a call.  A call is the opposite of a put.  When you buy a call you buy the right to buy a stock.  If you sold the $75 call for $1 that would have offset the cost of the put.  The only problem with this is that you would limit your profit.  If you sold the $75 call for $1 and the stock went to $80 you would have to sell it at $75.

     The protective put is a great way to help protect you from losses for a small fee.  It can be quite useful during times of uncertainty.