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Hedging Strategy – Protective Put
The next hedging strategy that we will discuss here is ‘Protective Put.’
Successful investors are concerned with managing risk effectively while they focus on maximizing returns. The main goal for investors should be maximizing risk-adjusted returns rather than total returns.
Options provide a great way to help manage risk with their tremendous flexibility and controllable costs. Protective put strategy helps in protecting the portfolio by incurring a minor cost. This strategy is widely used to help limit downside risk.
Protective put is a hedging strategy where the holder of a security buys a put to guard against a drop in the stock price of that security, which he already holds. This can also be applied to a basket of securities or portfolio. In case the trader wants to hedge the entire portfolio, an equivalent amount of Index puts can be bought.
It basically involves going long on a stock (either in cash segment or in futures) and simultaneously buy a put to limit the downside.
There is unlimited profit potential in this strategy. The protective put is also known as a synthetic long call as its risk/reward profile is the same as that of a long call.
The formula for calculating profit is given as:
- Maximum Profit = Unlimited
- Profit Achieved When Price of Underlying > Purchase Price of Underlying + Premium Paid
- Maximum loss for this strategy is limited and is equal to the premium paid for buying the put option.
- Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
- Breakeven Point = Purchase Price of Underlying + Premium Paid