Protective Puts

A protective put is an options strategy in which a shareholder buys a put option on a stock they already own. This gives the right to sell the stocks at a predetermined price (strike price) within a set time. If the stock market falls sharply, the value of the put option rises, which compensates for the losses on the shareholding.

This strategy works like an insurance policy, where the cost of the option is the 'premium' you pay for the protection. It is particularly relevant in uncertain market climates or when you want to keep a long-term position but protect against short-term volatility.

The strategy's effectiveness depends on several factors, including the chosen strike price and the option's term. A strike price near the current share price gives maximum protection but is also the most expensive, while a lower strike price gives cheaper but less comprehensive protection. The term determines how long the protection is active; a longer term gives the market more time to recover but costs more in premium.

For an institutional equity analyst, understanding this balance between cost and protection is crucial in order to recommend a strategy adapted to the client's risk profile and market outlook.

To carry out the strategy, a shareholder must first identify the stocks they want to protect. Next, a put option is chosen with a suitable strike price and term. If a stock trades at SEK 300, one can choose a put option with a strike price of SEK 280 and a three-month term. The premium for this option, say SEK 15 per share, is the direct cost of the protection. For every 100 shares owned, this therefore costs SEK 15 000.

If the share price falls to SEK 250 at expiration, the put option can be exercised, which means the shares are sold for SEK 280 instead of SEK 250, reducing the direct loss. Alternatively, the put option can be sold at a higher value before expiration to realize a gain on the option that partially or fully covers the loss on the shares.