Bullish on the underlying stock

An investor who purchases a put option while holding shares of the underlying stock is employing a  "protective put."

Application

An investor using a put as protection may have an unrealized profit from ownership of the underlying shares.  If he or she is concerned about downside risk in the near term, but still maintains a bullish outlook a protective put may be purchased as a form of insurance against a short-term pull back.

The investor retains all benefits of stock ownership such as dividends and voting rights.  At the same time, the protective put acts as a means of limiting downside loss in unrealized gains accrued since the  purchase of the shares. Regardless of how much the underlying stock decreases in value during the option's lifetime, the put guarantees the investor the right to sell his shares at the obtained strike price until expiration. If there is a significant decrease in the share price, the put holder has time to react. The purchase of a "protective put"  contract has created a guaranteed selling price at the strike price, and control over when the stock is sold.

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss:  Strike Price - Stock Purchase Price +  Premium Paid

Profitability depends on the potential of the underlying.  If the put expires in-the-money, any profit will off-set the loss in the underlying shares.  If the put expires at or out-of-the money the entire premium is lost.

The Implied volatility of an option is a measure of the amount by which the underlying security is expected to fluctuate over a period of time.  It reflects the markets expectations and can change at any time based on news or other events affecting the stock.

Volatility Increases:  Positive Effect
Volatility Decreases: Negative Effect

Any effect of volatility on the option's total premium is on the time value portion.

Time Decay?

Passage of Time: Negative Effect

An options time value portion will decrease as an option moves closer to expiration. The rate of time decay increases considerably with in the last month before expiration.  It is important to give yourself sufficient time for a move in the underlying to take place.  

To determine the time value portion of an options premium:

Premium - Intrinsic value = Time Value

Before expiration?

The investor is entitled to  sell his stock and/or his long put at any time before expiration. If the investor loses concern over a possible decline in share value, the put option may be sold if it has value.

Upon Expiration?

If the option has no value at expiration, then the holder may simply allow it to expire worthless and maintain possession of the underlying shares.  If the protective put has value, the holder may sell the contracts before the market closes, thus off-setting any loss incurred on the underlying shares.

An Example

For investors who put money in volatile sectors, the returns can be exceptional Unfortunately with the possibility of such reward,  comes the potential for great loss.  While the use of a protective put may limit the upside potential of the position by the cost of the put,  adding this option to the overall investment strategy will help the investors better position themselves for any market condition.

Using a protective put is a relatively simple and inexpensive means of insuring the  value of a portfolio.  For each 100 shares of stock, one protective put at a strike price close to the current market price is purchased.  If the concerned investor owned a stock stock trading at $21.00, a $20.00 or $17.50 put may be purchased. If the share price falls, he or she may be able to sell the stock for close to what they paid for it.

If the stock continues on its bullish run, the conservative investor will participate fully in the move, less the small amount paid for the protective puts. 

If Symantec Corporation (SYMC) is trading at $19.95, the investor would pay $1995.00 for 100 shares. If he or she are holding the shares on their own, the initial down-side risk is theoretically $1995.00. By purchasing one protective put (to cover all 100 shares) the amount you can lose is limited should the stock fall.

Regardless of how far the stock drops, with a protective put in place, this position will always be worth $1695.00.  (Strike Price - protective put premium).

If the stock continues to move higher, the investor may wish to roll the put up by selling the contracts initially purchased, and buy at a higher strike price. This will enable the investor to lock in profits as the stock continues to move forward. 

The investor may also sell a call (while owning the obligated shares) to help pay for the purchase of the protective put.  This strategy is called a collar.