If you were to pay $1.00 for a put and you owned stock against it, the stock would have to increase in price $1.00 just to break even. The protective put strategy has time premium working against it, thus the stock needs to move to a greater degree, and more quickly, to offset the cost of the put.

When we buy a stock, three potential outcomes exist. The stock can go up, go down or it can remain stagnant. If we were to analyze the three scenarios, we would find that only one scenario, the up scenario, can produce a positive return and that's only when the stock increases more than the amount you paid for the puts. The other scenarios produce losses. If the stock is stagnant, you lose the amount you paid for the put. If the stock goes down, you lose again- but the loss is limited. It is the limiting of loss in highly volatile situations that makes the protective put an attractive and useful strategy.

This is how it works! Imagine you buy stock for $31.00 and buy the 30 strike put for $1.00. If the stock goes down, the position will produce a loss. For example, if the stock is down to $30.00 (down $1.00) at expiration of the option, you have a $1.00 capital loss. With the stock at $30.00, the 30 strike puts will be worthless, thus you incur a $1.00 loss because that is what you paid for the put. Your total loss will be $2.00. Using the protective put strategy set a cap on your losses. The put strategy's attractiveness is that it will allow you to set loss limits!

Let's see how that works. We'll set the stock price down to $28.00. Since you purchased the stock at $31.00, there will be a capital loss of $3.00. The puts, however, are now in the money with the stock below $30.00. With the stock at $28.00, the 30 strike puts are worth $2.00. You paid $1.00 for them so you have a $1.00 profit in the puts. Combine the put profit ($1.00) with the capital loss ($3.00) and you have an overall loss of $2.00. The $2.00 loss is the maximum you can lose no matter how low the stock goes because the buyer of your put must take the stock at the strike price. This is the protection the put provides.


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