Part 1: Key Point In Protective Put Strategy & Value Options

Key Point - The protective put strategy, when used correctly, will allow investors to take advantage of some opportunities that could provide large potential gains without being exposed to the severe risks that normally accompany such risky opportunities. With the proper protection in place, the investor can profit from aggressive upside moves in the value options while having a fixed, limited loss.

As stated before, this strategy is not going to work all the time. However, there are some especially favorable opportunities for implementing the protective put strategy to value options.

One is the case of value options in the process of a steep decline. Quite often, value options experience bad news or break down through a technical support level and trade down to seek a new, lower trading range.

Everyone wants to find the bottom to buy and go long, catching the technical rebound, or to start accumulating the value options at lower levels for the longer term.

Although this scenario sounds good, these types of trades are risky. The risk is in identifying the true bottom. Value options that are in a freefall or rapid decline might give a false indication of a bottom which could lead to substantial losses to your value options. The protective put will provide protection against this kind of substantial loss to your value options.

Value options that go through a freefall finally “exhausts” or works through the sellers. The value options proceed down to lower levels where sellers are no longer interested in selling the value options.

At this level, the value options consolidate and buyers move in. Because the sellers are now done (exhausted) the pressure is lifted from the value options and they proceed up as buyers outnumber sellers.

There are models that are used to calculate where this bottom may lie, commonly referred to as “exhaustion models.” The problem is that the value options, on the way down, may stop and give the appearance of exhaustion but then continue further down. If you had bought at the false appearance of exhaustion, you could be looking at a big loss.

There is a potential for a very big reward if you pick the “right” bottom. However, with the big potential gain comes the big potential loss that is common in these types of risk/reward scenarios. Here is a perfect opportunity to employ the protective put strategy to your value options!

Remember, the protective put allows for a large potential upside with a limited, fixed downside risk. If you feel that the value options have bottomed out and are starting to consolidate, you purchase the value options and purchase the put.

If you are right, and the value options run back up, the stock profit will well exceed the price paid for the put. Once the value options trade back up, consolidates, and develops its new trading range, the need for the protective put is over. At this time, if you still like the value options and want to hold on to the long position, you could always start selling calls against it.

Calculate the loss in the value options and the amount you paid for the put and add them together for your maximum loss in this position. The protective put has limited your loss.

Maximum Loss = (Stock Price – Strike Price) – Option Price

This protection will save you enough money when you pick a false (wrong) bottom that you may, if you like, try to pick the bottom again at a lower point. The exhaustion scenario, as described here, is a perfect opportunity to apply the protective put strategy.

As seen with the exhaustion example, the protective put strategy is best used in situations where the value options have a potential for an aggressive upside move and the chance of a big downside move.