Protective Puts – A term insurance with benefits in a falling market
As part of our series on ‘braving the bear’ (Read: market actions you can undertake to benefit from the bear market), we recently discussed an option strategy on our blog – Covered Calls (Consider covered calls as an income generation strategy in bear markets).
As promised, we’re back with another strategy which could bring you a little cheer if markets fall – Protective Puts.
Once again, as in the case of a Covered Call, this strategy suits those of us who hold good long term stocks in our portfolio, the long term prospects of which we are bullish about.
But what if our short-term view is negative/bearish and we expect a price fall in the near future? Can we take advantage of it?
The answer is yes and the vehicle we use is a Protective Put Strategy.
A Protective Put is basically an insurance strategy, as it protects against a fall in the stock price. However, in a falling market, the difference between the price (premium) you pay to buy the put and its price at settlement could deliver gains.
In this strategy, you buy an at-the-money (ATM) or out-of-the-money (OTM) put option on the long-term stocks that you hold.
Of course, as the buyer a put option, you would have to pay the premium amount. But that is the maximum loss you could incur.
Let’s say you hold 400 stocks of HDFC BANK in your portfolio, which you have purchased at Rs 2200 per share.
From the low of Rs 2070 on 5th March 2019, the price has been rising to reach a high of Rs 2503 on 3rd July 2019, forming higher tops and higher bottoms.
Then from a high of Rs 2503, it started coming down and on 8th July, it gave a major breakdown of its rising trendline at 2439 levels and closed below its 10-day moving average (red in the chart below) and 30-day moving average (green in the chart below) supports of 2463 and 2441, respectively, at 2409, forming a bearish candle, with increasing volumes signalling a short-term trend reversal in the scrip.
All these indicate a negative /bearish short-term technical view on the stock and suggest a further fall in the price.
The time looks ripe here to enter a protective put strategy to insure the downside risk on your stock price.
On 8th July, HDFC BANK 25 JULY 2019 2400 PE (ATM Put option of July expiry) was quoting at Rs.28.80 and the lot size of HDFC BANK is 250.
By buying 1 lot of HDFC BANK 25 JULY 2019 2400 PE at a premium of Rs.28.80, you would have ‘protected’ your stock from the downside risk of a price fall.
Your maximum loss in this strategy would have been Rs.7200 (lot size * premium amount, i.e. 250 * 28.80)
The breakeven price (BEP) would have been 2371.20. Below this, as the buyer of a put option, you would have started making money (strike price – premium amount, i.e. 2400 – 28.80 = 2371.20)
How would it have panned out for you?
On expiry i.e. on 25th July, HDFC BANK closed at 2286 in the cash market, which is Rs.123 lower than its price on 8th July and your 25th July 2019 2400 PE would have been settled at Rs 110.75.
You would have made a profit of Rs.20,487.50!!
Basically, the difference between the price of the option at settlement (110.75) and the cost of purchasing it (i.e., the premium of 28.80) into the lot size of 250 would deliver this gain (81.95×250 = 20,487.50).
Here’s what you must keep in mind when you decide to buy protective puts…
If at the time of expiry, the put option has zero value, you face a maximum loss to the extent of the premium paid. So, effectively, the cost of the stocks that you own go up by the premium amount you have paid to enter the option. In our example, the cost per stock of HDFC BANK to you will effectively become Rs 2,228.80 (i.e., the Purchase cost of 2,200 + the Put premium amount of 28.80) if the option had expired with no value.
You May also like: Can you benefit from Market Volatility using a simple, low risk derivative strategy?
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.