Protective Put Strategy

What is a Protective Put?

A protective put is the options world's insurance policy. You own 100 shares of stock and buy 1 put option to protect against downside risk. That's it. Simple, powerful, and one of the few strategies Warren Buffett has publicly acknowledged using.

Think of it like car insurance: you hope you never need it, but if disaster strikes, you're protected. The put gives you the right to sell your shares at the strike price no matter how far the stock falls. If you own Apple at $180 and buy a $170 put, the worst you can lose is $10 per share, even if Apple crashes to $100.

The tradeoff: Protection costs money. The put premium is your insurance premium—typically 2-5% of stock value for 3-6 months of protection. This reduces your upside, but many investors gladly pay for peace of mind.

When to Use Protective Puts

Protective puts make sense in several scenarios:

1. Earnings Protection

You own a stock reporting earnings next week. You're long-term bullish but worried about a short-term miss. Buy a put expiring 2-4 weeks out to protect through earnings, then let it expire if earnings go well.

Example: Own 500 NVDA at $500, earnings in 2 days. Buy 5 NVDA $490 puts for $8 each. If NVDA crashes to $450 on disappointing guidance, your put gains $40, offsetting most of the $50 stock loss.

2. Market Uncertainty Protection

You're nervous about the market (Fed meeting, election, geopolitical event) but don't want to sell your long-term holdings and trigger taxes. Buy puts on SPY or individual positions to hedge.

3. Locking in Gains

You bought Tesla at $150, it's now $250, and you've got massive unrealized gains. You want to hold for long-term capital gains treatment (1+ year), but you're nervous about a pullback. Buy a $240 put to lock in most of your $100 gain while maintaining upside potential.

4. Concentrated Position Protection

You work at Google and have $500K in GOOGL stock (40% of your net worth). Company policy prevents you from selling for 6 months. Buy protective puts to reduce concentration risk without violating restrictions.

How to Set Up a Protective Put

Step 1: Choose Your Strike Price

Your strike determines how much downside risk you're willing to accept:

• At-the-money (ATM) put: Maximum protection, highest cost. Stock at $100, buy $100 put. Full downside protection from current price.
• 5-10% out-of-the-money: Good balance. Stock at $100, buy $95 put. You accept $5 loss, protect everything below $95.
• 10-15% OTM: Catastrophic protection. Stock at $100, buy $85-90 put. Cheaper, but you're exposed to the first 10-15% down.

Most common: 5-10% OTM puts. Provides good protection at reasonable cost.

Step 2: Choose Time Frame

Short-term protection (1-2 months): For specific events like earnings. Cheaper per month but expires quickly.

Medium-term (3-6 months): Most common. Protects through multiple events, reasonable cost.

Long-term (LEAPS puts, 12+ months): Very expensive but provides year-long peace of mind. Better cost-per-day than repeatedly buying short-term puts.

Example Setup

Scenario: Own 300 shares of Apple at $180 (cost basis $160). Worried about a correction.

Setup:
- Buy 3 AAPL $170 puts (5.5% OTM), 120 days to expiration
- Cost: $4 per share = $1,200 total (2.2% of position value)
- Protection: If AAPL drops below $170, puts gain $1 for every $1 stock loses
- Breakeven: AAPL needs to be above $184 at expiration to fully offset put cost

Profit & Loss Scenarios

Using the Apple example (own at $180, buy $170 put for $4):

Scenario 1: Crash to $150

• Stock loss: -$30 per share
• Put gain: +$20 per share ($170 strike - $150 price)
• Net loss: -$10 per share (stock loss $30 - put gain $20)
• Plus put cost: -$4
• Total loss: -$14 per share vs -$30 without protection (53% loss reduction)

Scenario 2: Sideways at $180

• Stock: unchanged
• Put expires worthless: -$4
• Total: -$4 per share (2.2% insurance cost)

Scenario 3: Rally to $200

• Stock gain: +$20 per share
• Put expires worthless: -$4
• Total: +$16 per share (vs +$20 without protection)

Key insight: Upside is reduced by put cost, but downside is dramatically limited. Perfect for risk-averse investors or uncertain times.

The True Cost of Protection

Protective puts aren't free. Let's break down the real costs:

Annual Cost Example

Stock position: $100,000 in various stocks

• Buy protective puts 5% OTM, rolling every 3 months
• Cost per quarter: $2,000 (2% of portfolio)
• Annual cost: $8,000 (8% of portfolio)

Is this worth it? Depends on your goals:

• If market crashes 20%: You save $12,000, net gain $4,000
• If market is flat: You lose $8,000 (wasted insurance)
• If market rises 15%: You gain $15,000 on stock, paid $8,000 protection, net +$7,000

Cost-reduction strategies:

• Buy further OTM puts (10-15% vs 5%): Reduces cost 40-50%
• Accept first 10% loss unprotected: Dramatically cheaper
• Only protect during high-risk periods: Earnings, Fed meetings, etc.
• Use put spreads instead of naked puts: Caps max gain but cuts cost in half

Protective Put vs Other Strategies

Protective Put vs Selling Stock

Protective Put vs Collar

A collar adds a short call to the protective put, using the call premium to offset put cost. This reduces or eliminates insurance cost but caps your upside.

• Protective put: Costs money, unlimited upside
• Collar: Free or low cost, upside capped at call strike

Protective Put vs Stop Loss

Advanced Protective Put Techniques

1. Rolling Protection Forward

When your protective put has 30-45 days left and is OTM, sell it for remaining value and buy a new put 3-6 months out. This maintains continuous protection.

2. Adjusting Strikes After Rallies

Stock rallies from $100 to $120. Your $95 put is now far OTM and provides little protection. Sell it, use proceeds toward a $110 put to protect new higher price level.

3. Put Spreads for Lower Cost

Instead of buying a $170 put for $4, buy a $170/$160 put spread for $2. You're protected from $170 down to $160, but give up protection below $160. This cuts cost in half while maintaining protection against moderate drops.

Key Takeaways