You can hedge your stock positions by purchasing puts.
Buying puts is a straightforward strategy that offers protection for your assets and the potential to profit during a bear market. If you anticipate a market downturn, buying puts can be a more advantageous option than selling your stocks or shorting them through a margin account.
Who needs put options?
Put buying is a strategy that some investors use to hedge their existing stock positions. By paying the premium, you can secure a selling price, safeguarding yourself against any decline in the asset’s value below the strike price until the option expires. If you choose to exercise your option, the put writer is obligated to buy your shares at the strike price, no matter the stock’s current market value.
However, if the stock price rises, you can still benefit from the increase by letting the option expire and holding onto your shares. In this scenario, your maximum loss is limited to the premium you paid for the option.
Speculators who anticipate a bearish market often buy puts to capitalize on a market downturn. As the price of the underlying equity falls, the value of the put option typically increases, allowing it to be sold at a profit. The potential loss is predetermined and usually smaller, making put buying more attractive than other bearish strategies, such as short selling.
Married put strategy
When you purchase shares of the underlying stock simultaneously with a put option, the strategy is called a married put. If you already own the stock and then purchase a put, it’s known as a protective put. Both strategies offer the benefits of stock ownership—such as dividends and voting rights—while also providing downside protection through the put option.
Owning the underlying stock generally reflects a bullish outlook on the market, which contrasts with other long put strategies. If you believe a stock’s value will increase but want to protect your portfolio against potential declines, a married put can safeguard your investment. Similarly, a protective put can help secure unrealized gains on stocks you’ve held, offering a safety net if their value starts to decrease.
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Short a stock vs long put option
When you sell stock short, you borrow shares from your brokerage firm on margin and sell them on the open market. If the stock price drops as you anticipated, you can buy back the same number of shares at the lower price and return them to your brokerage firm, with the difference between the sale price and the repurchase price being your profit. For many investors, buying puts offers an appealing alternative to shorting stock.
| Shorting stock | Long a PUT |
|---|---|
| Shorting stock requires a margin account with your brokerage firm. A short seller also faces the possibility of a margin call if the stock price rises, and could be forced to sell off other assets. |
Puts are purchased outright, usually for a much lower amount than the margin requirement, so you don’t have to commit as much cash to the trade. |
| Shorting stock involves potentially unlimited loss if the price of the stock begins to rise and the shares have to be repurchased at a higher price than they were sold. |
A long put poses much less risk to an investor than shorting stock. The holder of a put always faces a predetermined, limited amount of risk. |
| Investors can short certain stocks, but only on an uptick, or upward price movement. The uptick rule is meant to prevent a rush of selling as the price of a security drops. |
Puts can be purchased regardless of a stock’s current market price. |
Calculating your return
When you buy a put, your maximum loss is capped at the premium you paid for the option, making it easy to calculate your potential loss—just add any fees or commissions to the premium. You’ll incur this loss if the option expires unexercised or remains out-of-the-money.
If you foresee a potential loss, you can sell the option before expiration to recoup some of the premium, potentially reducing your overall loss. However, the market price of the option will likely be lower than what you initially paid.
| Purchasing to Hold or Sell the Option |
Purchasing to Hedge a Stock Position |
|---|---|
| If you purchase a put and later sell it, you can calculate return by figuring the difference between what you paid and what you received.
For example, say you purchase one XYZ put for $300, or $3 per share. A month later, the price of the underlying equity falls, placing the put in-the-money. You sell your option for $600, or $6 per share. Your return is $300, or 100% of your investment. $600 Sale price If the price of the stock has risen after a month, the put is out-of-the-money, and the premium drops to $200. You decide to cut your losses and sell the put. $300 XYZ put price |
If you purchased the put to hedge a stock position, calculating your return means finding the difference between your total investment — the price of the premium added to the amount you paid for the shares — and what you would receive if you exercised your option.
For example, if you purchased 100 XYZ shares at $40 each, you invested $4,000. If you purchased one XYZ put with a strike price of $35 for $200, or $2 per share, you’ve invested $4,200 total in the transaction. If you exercise the option, you’ll receive $3,500, for a $700 loss on your $4,200 investment. $4,200 Total investment A $700 loss might seem big, but keep in mind that if the price of the stock falls below $35, you would face a potentially significant loss if you didn’t hold the put. By adding $200 to your investment, you’ve guaranteed a selling price of $35, no matter how low the market price drops. |
Buying Put Options – How Does It Work? by Inna Rosputnia
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