A Protective Put is Like Stock Insurance Against a Market Crash

A protective put lets you lock in your investment profits without selling your stocks. Think of it like insurance. It’s something you buy…but hope you never use.

You buy homeowner’s insurance because if a tree falls on your house, insurance will cover the repairs. Obviously, you don’t want a tree trunk in your living room, but it’s nice to know that if something crazy like that happens, you’re protected.

Of course, insurance isn’t free. You’re willing to pay for it, however, because the premiums are lower than what it would cost you to repair your house after a catastrophe.

Contents:

• What is stock insurance, and how do you get it?
• How to profit even if shares fall.
• Strategy comparisons.
• Which strategy should you pick?

Take the idea of insurance, and apply it to your investments.

Imagine that you bought 100 shares of Amazon (AMZN) stock at the end of 2016 for $38 per share. Five years later, at the end of 2021, AMZN sold for $167. That meant you were sitting on a gain of 339%!

But now let’s pretend it’s December 2022.

At that point, Amazon’s stock had crashed 44% in less than a year. That meant your investment had “only” grown 147% in the 6 years that you owned your shares.

Now let’s also imagine that you still believe in Amazon as a company, and you want to hold your shares. But watching your profit shrink from 339% to 147% is like getting punched in the gut…before getting stomped on while you’re on the ground crying.

So, what should you do?

You don’t want to sell because you believe in the company. At the same time, you don’t know how much more your emotions can take as you watch your portfolio continue to dwindle.

One option is to buy “stock insurance.”

In reality, stock insurance isn’t a thing. But you can get the same benefits of insurance if you buy a put option. A put option protects you if one of your stocks drops a catastrophic amount. That’s why this strategy is often referred to as a protective put.

Here’s how a protective put works:

Let’s flash back again to December 2022. AMZN was trading for $94. Again, you watched the stock drop 44% that year, and you’re afraid of losing all your profits.

You could just sell and lock in your gains, but if you do that, you’ll miss out any profits when the stock rebounds. As long as you own the stock, you theoretically have unlimited upside. You lose all that upside, however, the moment you sell.

But what if you could lock in your profits without actually selling your stock?

You can…with a protective put.

Let’s say AMZN dropped to $75. Your gains would “only” be 97% at that point. That’s not bad. You still would have nearly doubled your money in 6 years. But also remember that less than a year ago, you were up 339%!

As we said, you believe in Amazon as a company. You’ve held on this long because you think the stock will rebound. Still, it’s wise to have a risk management strategy to protect you from catastrophe.

That’s where buying a put option comes in.

If you buy a put at $75, it means that you won’t lose any more money if AMZN drops below that point. If it does, you’ll actually make money!

Perhaps even better, you’ll still keep your unlimited upside potential. AMZN could drop below $75 but then rebound sharply and continue to climb. That’s exactly what’s happened so far in 2023.

But if you sold your shares at $75, you would have missed out on those gains. With a protective put, however, you would have kept your shares without taking on any more downside risk below $75.

Buying put options: profit even if shares fall.

I’ve written extensively about buying calls in a previous article. Buying a put is the opposite. Instead of betting that a stock’s price will rise, you expect it to fall.

Since we’re talking about “stock insurance,” we’re using a protective put. A protective put is a risk-management strategy that guards you from losing money on a stock that you already own.

That last phrase is key. You don’t actually want the stock to fall like you would if you were buying a put option against a stock you don’t own. With a protective put, you are buying peace of mind and a safety net for your profits.

Let’s use our AMZN scenario again. Pretend it’s December 2022, you’re up 147%, and you don’t want to lose all those gains if the stock crashes even more.

Let’s use $75 as your bail-out point. If the stock drops below that price, you’re out. At that point, you’ll have two choices:

1. Simply sell your shares if the stock drops to $75 or lower.
2. Hold your shares with the assurance that even if the price drops below $75, not only will you NOT lose money, but you’ll actually make more money as AMZN continues to fall!

Choice 2 is your stock insurance.

When you buy a put, you have the option (but not the obligation) to sell shares at your strike price (in this case $75). In other words, even if AMZN drops to $70 (or lower!), you can still sell your shares for $75.

That’s why I call this stock insurance. If your stock drops below your strike price, the protective put will pay for that “damage” just like an insurance company.

With a protective put, you are buying peace of mind and a safety net for your profits.

There’s always a catch.

But, alas, just like insurance, protective puts aren’t free. You have to buy stock insurance in the form of an options premium.

Returning to our AMZN example, let’s say that you’ve determined that there’s still a risk of the stock falling significantly in the near term. So, you buy a put with a $75 strike price that expires 5 months out.

Let’s say that the premium for that trade is $2.80. Options contracts are for 100 shares, however. Your cost would therefore be $280 ($2.80 premium x 100 shares). Think of that as your insurance premium.

Again, you don’t actually want AMZN to fall. You want the price to soar so that you can regain the profits that you lost over the last year. But just like with regular insurance, when you buy a protective put, you are buying peace of mind and protection.

So far, we’ve discussed two risk management strategies:

1. Simply sell your shares if they fall to $75.
2. Buy a protective put with a strike price of $75.

But strategy #2 also leaves you with another choice. You have to decide if you are going to exercise your option or sell it.

Below is a summary of all three of your choices (selling shares, exercising the option, or selling the option). Afterward, I’ll review the pros and cons of each strategy.

Strategy 1 — Sell your shares at $75.

• AMZN continues to fall, so you sell your shares outright at $75. You collect $7,500 ($75 x 100 shares).
• You originally purchased those shares in 2016 for $3,800 ($38 x 100 shares).
• That’s a profit of $3,700 or 97%.

Strategy 2 — Buy a protective put at $75 and EXERCISE your option.

• You buy a protective put at $75 for a premium of $280 ($2.80 premium x 100 shares).
• AMZN falls all the way to $70.
• You exercise your protective put.
• To calculate the profit of this trade, use this formula:

(AMZN sell price – AMZN purchase price – Put premium) x Number of shares

• Exercising your option nets a profit of $3,420 (($75 sell price – $38 purchase price – $2.80 premium) x 100). That’s a 90% gain.

Strategy 3 — Buy a protective put at $75 and SELL your option.

• You buy a protective put at $75 for a premium of $280 ($2.80 premium x 100 shares).
• AMZN falls all the way to $70.
• You sell (NOT exercise) your protective put option.
• Since your put option trade is now in the money (ITM), it has an intrinsic value of $5 ($75 – $70). The total price for the put will depend on several factors, most importantly how much time remains before expiration. For this example, we’ll assume that a $75 ITM put will sell for $6.30. (Note: if you need a refresher on time value and why most options are sold instead of exercised, see this article.)
• To calculate the profit of this trade, use this formula:

(Put Sell Price – Put Purchase Price) × Number of shares

• Selling your option nets a profit of $350 (($6.30 Put sell price – $2.80 Put purchase price) x 100). That’s a gain of 125%.

Which strategy is best?

To decide which strategy is best, you could simply pick the one with the highest net gain or the greatest percentage gain. Since this is a risk management strategy, however, you should consider other factors as well.

Let’s review the merits of each choice.

Strategy 1 — Sell your shares at $75.

The best part of this strategy is its simplicity. If AMZN falls to $75, you just sell your shares. But while the process of selling shares is easy, selling at exactly $75 is trickier.

Large price movements

First, stocks trade even when the market isn’t open, both before the opening bell and after the close. During these after-hours sessions, stock prices can move considerably, especially after an earnings report or in response to significant news.

This means that AMZN could close one day at something like $76 but open the next day at $72. The price would fall right past your $75 breaking point before you could sell.

Some investors choose to enter a stop-loss order to cut their losses at a certain price. A stop-loss order tells your broker to sell a stock when it reaches a specific price. When the stop-price is met, the order becomes a market order, which means that the order is executed at the next available opportunity.

If you enter a stop-loss order to sell AMZN, you would automatically sell your shares when the price drops to $75. Well…that’s how it’s supposed to work anyway.

There are multiple disadvantages with stop-losses. The first problem results when a stock gaps down. This could happen because of after-hours trading or some other factor that significantly and suddenly moves the stock price. If that happens, your AMZN shares would be sold at the next available price, even if the stock is trading sharply lower than your stop-loss level.

Choppy markets

If the stock’s price is quickly moving up and down, your stop-loss could trigger just before the stock reverses itself and resumes an uptrend. That would result in you selling your shares at $75 only to watch the stock rise from there.

Loss of upside

The greatest disadvantage of selling your shares outright, however, is the finality of it. Once you sell, those shares are gone. As I mentioned already, this means that you will miss out on any potential gains when the stock rebounds.

Of course, if you no longer believe in AMZN, that’s different. If that’s the case, sell your shares outright and be done with the company.

If, however, you still believe in the business, you may want to consider a different risk management strategy (see strategies #2 and #3).

Strategy 2 — Buy a protective put at $75 and EXERCISE your option.

Strategies 2 and 3 both involve buying a protective put. A protective put has a significant advantage over simply selling your shares if they fall to your bail-out point. With a put, not only are you protected against a steep fall in price, but you will also maintain your unlimited upside potential.

The difference between strategies 2 and 3 is whether you exercise your option or sell it. (To read a more detailed explanation of the difference between exercising and selling options, see this beginner’s guide.)

As we discussed in the previous section, stock prices constantly change. In our scenario, AMZN could easily drop below $75 but then bounce right back above it within a day or two…or even within the same day.

If, however, you use a protective put, you can still reap the profits of a rebound. That’s because you don’t have to exercise your option if AMZN drops below your strike price. You have until the expiration date to make that decision.

So, if AMZN drops to $70, you could exercise your option and make the profits that I calculated above. There is no reason to do that early, however. Remember, a protective put is insurance. You buy it, but you hope you don’t have to use it.

You would be better off waiting until the expiration date to see what AMZN does. Waiting has 2 benefits:

1. There’s little risk. If the price never rebounds, you can exercise your option up to the expiration date. You’ll sell your shares for $75 regardless of what they’re trading for on the open market.
2. Waiting gives your shares time to rebound. Ideally, the price will climb, and you’ll never have to use your “stock insurance.” Since you still own your shares, you’ll reap the benefits of the rebound. Contrast that with if you sold at $75. You’d miss out on any future gains.

Buying a put, therefore, gives you the benefits of both worlds. You’re protected against a crash and you still maintain your upside potential.

But what if AMZN crashes, and you do exercise your option?

If AMZN drops below $75 and the option expiration date approaches, you could exercise your option as described in the Strategy 2 section above. In that case, you would end up selling your shares but at a higher price than the market.

You end up at the same place as Strategy #1 — you no longer own your shares. The difference is that you are able to sell your shares at $75 even if AMZN is trading for well below that price. Of course, you’ll also be out the premium you paid for that protection.

It’s rare to exercise an option, however. That’s because you will almost always make a better profit by selling the option instead of exercising it.

When you sell it, you’re able to capture not only the intrinsic value of your position, but you’ll also reap the time value. Selling an option instead of exercising it also avoids additional costs resulting from commissions (since there are multiple transactions) and margin interest (if it’s a short sale).

That bring us to strategy #3.

Strategy 3 — Buy a protective put at $75 and SELL your option.

In this strategy, you will still make money if AMZN drops below $75, but the major difference is that you will still own your shares. That’s because unlike with Strategy #2, you will sell your option before it expires instead of exercising it.

In our scenario, this strategy resulted in the highest percent gain (but not the greatest dollar amount). It’s also very easy to execute — you just make a few clicks in your trading platform.

Another benefit is that you still own your shares. You’ll make money if AMZN drops below $75. But unlike the other two strategies where you sold you shares, if AMZN rebounds after the expiration date, you’ll reap the benefits of that rebound. In other words, you’ll profit when AMZN drops and when it rises, even if that rise comes much later than you expected.

But what if you’ve had enough with AMZN and you want to dump your shares?

You can still use this strategy to profit from the fall in price. Sell your put option just like I described above. Then, sell your AMZN shares on the open market like a normal stock trade.

This process lets you capture the full value of your options trade (both intrinsic and time value), and you can still sell your shares if that’s what you want to do.

Also, if you no longer believe in AMZN and think that the stock will continue to fall, you could also buy another put option. That would let you profit when AMZN drops. That’s a different strategy than a protective put, however, so I’m not going to cover that here.

Summary of strategies

As I said, each of our three risk management strategies has merit. It all comes down to what you want to do with your shares.

If AMZN dropping to $75 will make you lose faith in the stock, Strategy #1 could be your best bet. It’s simple, and you can easily dump your shares whenever you feel like it.

If, however, you want to hold onto AMZN but you also want to protect your profits, then Strategies 2 and 3 are good choices.

What if the stock never drops? Didn’t I just waste money on the protective put?

If AMZN never hits your strike price or if it climbs from here, that’s great! Since you own the shares, you’ll benefit from those gains.

When the option expiration date arrives, your trade will expire worthless. (It’s worthless because you would never exercise a $75 strike when you could sell your shares on the open market for more than that.)

Of course, if AMZN rises and your option expires, you’ll lose the premium you paid. You might be tempted to argue that in that case, you would have been better off if you never purchased the protective put.

If you start to feel that way, remember why you made the trade in the first place. It was insurance against losing even more money. And just like with any insurance, you’re paying for peace of mind and protection. You received both of those when you bought the put. Granted, it also decreased your profits by the price of the premium. Only you can determine if that price was worth the emotional and mental benefits as well as the financial hedge you received.

What to do after your put expires.

If a protective put expires worthless, some investors choose to buy another one to continue their risk management strategy. They simply select another expiration date and follow the same process. Since the stock rose, however, they will choose a higher strike price that reflects that change.

For example, if your AMZN stock rose to $125, you might buy a put with that strike price or a little lower. It all depends on how much profit you want to protect — if you want to protect it at all. You could decide that the downside risk is no longer high enough to warrant purchasing “stock insurance.”

Should I always use a protective put to protect my profits?

No!

Protective puts are best used if you have significant money invested in a stock and/or you’re sitting on large, unrealized gains. That’s because you need to be able to make enough money if the stock rebounds to cover the amount you paid for the put. If you only own a couple shares of a company, it would take an enormous price jump to make up for the cost of the premium.

An insurance analogy can help illustrate this point:

If you have significant assets, you probably own or have at least considered an umbrella insurance policy. Since you stand to lose so much if you’re at fault in an accident or some other event, it likely makes sense for you to buy extra insurance to protect yourself.

On the other hand, if you’re just starting out and/or you don’t have a a large net worth, it’s probably not worth buying extra insurance. Take the money you would have spent on the policy and invest it.

The same logic applies to a protective put. If you’re at risk of losing significant profits, it makes sense. But if the cost of the premium is more than you stand to gain or protect, it’s not worth it.

Lastly, before buying a protective put, you should have a solid reason to believe that a significant, prolonged downturn could occur soon. Usually, that’s because of an overall bear market or other macro factors.

Of course, if you believe the company is in trouble, its fundamentals are no longer sound, and/or your reasons for initially buying the stock are no longer valid, you should NOT be invested in it at all. You’re much better off selling your shares and moving onto a better business.

Don’t forget about commissions.

One aspect of protective puts that I didn’t mention is broker commissions. In addition to the premium, you’ll pay a commission when you trade options. For simplicity’s sake, and because commissions vary across brokers, I didn’t factor them into our profit calculations. Be sure to consider these charges before opening a trade.

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This article is for informational and educational purposes only. It is not financial advice in any way. Read the full disclaimer for more details.