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Insure Your Share Investments Using Protective Puts
Education | 05 April 2012
By: Tho Mun Yi
Articles (2) Profile

Protective Puts is a trading hedging strategy using options or structured warrants where it is applied as a hedge against a decrease in share prices.

Consider this, a stock investor has the choice of “buying an insurance” on the price of the shares that he is holding at current price. In the event where the share price falls below the current price, the “insurance” would cover any decrease in the share price. With this strategy, stock traders can keep holding on to their shares longer, reaping more future profits, if any, while reducing their risks.

Even if your insurance is not used, you still pay a premium for its protection, right? The exact same concept applies for Protective Puts as well. Protective Puts, put simply is to buy put options or warrants which are at the money anytime you decided you want to “lock in” your share’s profits. A premium will be charged for the put option or warrant. This is very much like having to pay for the premium of an insurance policy. If the underlying share price continues to go up, the put option or warrant will expire out of the money at minimal cost.

With the Protective Puts in place, any depreciation in the stock price will trigger an equivalent appreciation in the put options.

Your maximum loss is limited to the premium you must pay for the put option, while your maximum gains (pertaining to the stock you’re holding) are unlimited as the market rallies.

This is how it works:
Let’s say an investor bought Share C on December 30 2011 for $2.20 which is currently worth $3.00 which he has not sold, giving him unrealised profits of $0.80. The investor chooses not to sell the share yet, as he thinks its price will go up further, yet at the same time he would like to ensure he does not lose his unrealised gains of $0.80.

What the investor can do is purchase at the money put warrant for the same stock with the exercise price of $3.00 with a premium of $0.40. This will protect the investor so long as the warrant remains in force. In the event that the share declines from $3 to $2.20 or even to $1, the investor’s losses are limited to the premium paid for the protective put. This is because while the price of the stock decreases, the value of the put warrant increases. On the other hand, if the stock price continues to climb to let’s say $4.20, the investor will be able to enjoy the returns from this increase too.

Profit calculation for Stock C with a purchase price of $2.20:

Protective Puts are ideal for risk-averse investors. On top of that, the investor who utilizes a protective put will retain all the benefits of stock ownership which include right to the company’s dividends and voting rights.

Insuring your share investments while still enjoying your stockholder rights is just a Put away.

Tho Mun Yi is a licensed Associate Financial Planner Malaysia. She is also a fulltime unit trust consultant since 2008. Her financial and academic articles have been published by various publications and websites.

She can be contacted at thomunyi@gmail.com

Please click here for more information about this author.


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