Before every protective put trade it is possible to calculate your anticipated maximum loss. Use the formula: (stock price minus strike price) plus option price. For example, suppose you will pay $30.00 for your stock, and you want no more than a $3.50 loss on the position. Then you would choose the $27.50 strike put which costs $1.00. Following the formula, you take your stock price ($30.00) and subtract the put's strike price (27.50) which leaves you $2.50. To this $2.50 loss, you then add the amount you spent on the option ($1.00), which gives you a combined, maximum loss of $3.50 for this position. You can set your loss limit by the strike price of the put you buy and the cost of the put. This formula will work every time. Remember, stock loss, (stock price paid - strike price), plus option cost (option price) equals maximum potential position loss.

The protective put strategy, when used correctly, will allow investors to take advantage of the same opportunities that could provide large potential gains, but without being exposed to the extreme risks the position could potentially present. In these scenarios, the protective put strategy deserves consideration.

For example, a stock in the process of a steep decline would be a good opportunity to implement a protective put, when trying to pick a bottom. Quite often, stocks 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 stock at lower levels for the longer term.

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! It will provide protection against substantial loss, while allowing room for potential gains if the stock should bounce.

Remember, the protective put allows for a large potential upside with a limited, fixed downside risk. If you feel that the stock has bottomed out and is starting to consolidate, you purchase the stock and then purchase the put at the same time as insurance against further decline in the stock.

If you are right, and the stock runs back up, the stock profit will well exceed the price paid for the put. Once the stock trades 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 stock and want to hold on to the long position, you could always start selling calls against it.

Use the formula for maximum loss discussed earlier. Calculate the loss in the stock 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.