What is a protective put?
A protective put is as its name implies, a form of insurance to protect a long position held in a stock. Buying a protective put insures the stockholder a maximum loss of the put's strike price.
For example (see diagram) if the shareholder has 100 shares of stock ABC with a share price of $52, then a contract (1 contract=100 shares) can be purchased to limit losses at the strike price of the option. Let's say the option strike price is $50, then the maximum loss per share is $2 plus the premium paid (the cost of purchasing a contract). Let's say the premium for a contract is $2 (1 contract =100 shares=$200), then the maximum loss in the trade is $400. On the other hand, the profit potential is unlimited if the share price goes up and the only loss is that of the premium paid of $200. If the stock reaches $54, then the shareholder has broke even in the trade and realizes only profit as the stock goes up.
So the key aspect of the protective put is that it minimizes loss in the case of a bad earnings report, share dilution, etc. Are protective puts a valid strategy?
Some would say that buying protective puts is not a good strategy for the risk averse. The argument here is that the risk averse should stay away from stocks altogether and focus on less risky instruments such as bonds. However, for the astute investor, protective puts can provide a useful tool, for example, during times of higher risk such as right before an earnings report is announced, or just prior to a FDA announcement on drug approval. If premiums are purchased just before news and just before the front month expiration, the loss incurred will be minimal if the stock averts disaster and heads skyward.
It is good to think of options in this sense like any other type of insurance (car insurance, homeowner's insurance, etc.). It seems like a waste of money if there aren't any problems, but if there are, you are glad you have it. Types of stocks to consider a put strategy in
The types of stocks that are the best to use the protective put strategy on are highly volatile stocks with extreme amounts of upside and downside. The best example that comes to mind are small biotech stocks in which the success or failure of the company relies on a binary yes/no decision by the FDA. If the drug is accepted, then the stock often skyrockets, but if it fails these stocks can almost go to zero overnight. In this case a great strategy is to buy the stock and protective puts immediately before the announcement and if approval is won, the loss of the premium paid will seem like nothing compared to the extreme amount of profits that are possible.
Other types of stocks that can work well with this investment strategy include other small cap stocks, volatile ETFs and index funds that commonly exhibit large price changes.
Stocks to stay away from with this strategy would be large, stable blue chip stocks that are typically much less volatile. Paying for protective puts in the case of these stocks is much more likely to result in futile expiration and loss of the premium.