Here's how protective puts work in practice.

Protective Puts

Investors pursuing a protective put strategy attempt to limit the unknown, downside market risk involved with owning the underlying stock. Simultaneously, they preserve their profit potential from increases in the stock's price.

Protective puts are often described as a classic example of insurance. Because put options are used to transfer risk between parties, the put writer can be viewed as a seller of insurance. In exchange for the put premium, the writer will bear the risk of an asset for the put holder. The chart below demonstrates the profit profiles for buying a stock as well as buying a put option.

By combining the long stock and put, one can see the profit profile for a protective put. By purchasing the put option, the investor limits his or her downside market risk to the premium amount required to buy the put option. Since he or she has a guaranteed price to sell the shares, the investor has time to react if there is a dramatic decrease in the value of the stock.

Although it is lowered by the premium amount, the investor still retains any profits resulting from increases in the underlying stock's value. Moreover, the investor preserves his or her dividend and voting rights during the life of the put option as long as he or she owns the stock. Protective put strategies are quite effective for investors that want to protect unrealized profits from gains in stocks that they currently own.

Because of its design, investors use protective puts when the volatility of a particular stock is unknown or anticipated to be relatively high in the short term.

They greatly decrease the risk involved with stock ownership. In the below example, an at-the-money put option with a $40 strike price is written on an underlying stock. Even if the stock value decreases to zero, the most an investor could lose is limited to the purchase amount of the put premium, $200. However, once the stock price rises above the break-even point of $42, the investor recoups the put premium and begins realizing a profit.

The investor's profit potential is limitless since the stock price can rise indefinitely. For this reason, investors benefit from stock prices that have large amounts of volatility during the life of the put option.