A protective put strategy is an option trading strategy that lets you protect profits you’ve already earned from being long in a particular stock.  Rather than entering a stop loss order which would sell your position once the stock fell to a certain price, protective puts let you protect your downside risk without automatically closing out your position in the process.

Rather than give you a technical protective put definition, here’s an example of how a protective put option works which will make how this strategy protects your profits clear.

Suppose you bought 100 shares of a certain stock at $20 and it’s now trading at $27.  You hope that it still has some upside potential to grow but you want to protect your gains in case the price does reverse trend and start falling.  Your first option is to enter a stop order at, say, $25.  That would protect $500 in profits but once the $25 price is reached it would also result in closing out your entire position.  If that price drop was only temporary, you’d lose out on any potential gains should the price again rise.

Instead of going all or nothing with a stop order, a protective put lets you protect your profits without closing out your position.  Instead of placing that stop order at $25, you would instead buy a put option with a strike price of $25.  Then, if the stock price falls to $25 or below, you have the option of exercising your put option and selling at $25 thereby guaranteeing that, no matter how far the stock price falls, your $500 profit is locked in.

The downside of a protective put options strategy is that you need to buy the put option contract which will reduce your profits by the premium value of the contract.  So, if the contract is trading with a premium of 1 ($1 per share) then, continuing the above example, your maximum profit using a protective put is $500 – $100 or $400.  But, if the stock you own is volatile and you want to make sure that a temporary drop in share price doesn’t cause a liquidation of your position as would happen with a stop order, then a protective put might be worth the additional cost.

So, the primary advantage of a protective put is that it lets you lock in profits in a stock you already own.  Without this downside protection, your downside risk is theoretically your entire investment should the stock price go to zero.  With a protective put, you lock in your maximum loss to the difference between the strike price and what you originally purchased the stock for (minus the premium paid for the protective put contract of course).

You’re retaining the unlimited upside of potential future gains in the stock price, preserving your position in case of temporary drops in share price, and reducing your risk from a potential total loss to a calculated and fixed loss with a protective put.