Buying protective puts can be very useful in the stock market. Whenever the markets start to get volatile many traders will use this strategy as a way to protect them from any downward movement their stock could have. How can they do this you ask. It is actually really simple.
To understand how a protective put works you should first be able to understand what a put option is. When you buy a put what you are actually doing is buying the right to sell a stock at a given price by a given day.
For example if you buy the $40 DEC put for stock XYZ you can sell XYZ for $40 by the 3rd Friday of December. This is true even if XYZ is trading far below $40 by then.
Now how can you apply this to protect you from the downside? Say you own a stock. It is currently trading at $72. The market has been volatile lately and you are afraid that your stock is going to go lower.
What you could do is buy the $70 put options for your stock. This cost you about $1. Now if the stock goes down to say $63 it is not so bad. Because you bought the $70 put you have the option to sell your $63 stock for $70. You would take just a small loss of $2+$1=$3, as opposed to $9.
The disadvantage to buying protective puts is you spend money to do it. If your stock went up then you lost that $1. It really served no purpose. Your put just expired worthless. Some traders see it as buying insurance, just in case. If they need it then that's great, if they don't oh well.
Others will try to offset the cost of buying the put by selling a call. This 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 covered 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.
In the end it all depends on you. The protective put can help protect you from losses for a small fee. It can be quite useful during times of uncertainty.
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