A protective put is a risk management strategy that traders can use to control potential losses on their asset holdings through Options contracts. The strategy is often used to manage the risk of a long position by buying Put Options. For example, when the buyer expects the price of the holding asset to rise, but the price falls due to unpredictable market volatility.

 

A protective put strategy consists of an asset held and a Put Option. A trader using this hedging strategy will pay a fee for buying a Put Option, which is called a premium.

Key Points for Creating a Strategy

A protective put strategy is achieved by buying the same contract value of Put Options as that of the asset you hold. For example, if you hold 1 BTC, you need to buy 1 BTC of Put Options.

 

Entry Time

First, traders need to figure out the right time to buy Put Options. 

 

A protective put strategy can be a good risk-management tool in the face of a prearranged event in the market, but it’s unclear how it will affect the investment market. For example, any decision made at the upcoming Federal Reserve (Fed) meeting will impact the investment market, but traders aren’t sure what kind of changes the meeting will bring to the market.

 

In this scenario, it would be a good idea to create a protective put strategy by buying Put Options before the meeting. 

 

Validity Period 

The expiration time of the Put Option is the end of the protective put strategy’s validity period As protective put strategies are often used to hedge against uncertain changes caused by market events, traders should note that the expiration date of the Put Options purchased should match the validity period of the protective put strategy.

 

If you want to hedge short-term risk, it's a good idea to buy short-term Options to create a protective put strategy. For example, to hedge against uncertainty arising from market events that will take place tomorrow, it would be appropriate to buy Put Options that expire within a week. This is because long-term Options are less price-volatile than short-term Options, which may not be able to hedge risks well.

 

In general, short-term Options refers to Options that expire within one month, while long-term Options are those that expire in more than a month.

 

Strike Price

The strike price of the Put Option is a line of safety for this hedging strategy. If the price of the underlying asset falls below the strike price when the Option expires, the trader's loss of a Put Option used in a protective put strategy is limited.

 

Therefore, choosing the right Option strike price is crucial. Generally, at-the-money (ATM) Options are preferred because of their higher sensitivity to market volatility (as reflected in delta and gamma values) and lower Option prices (as reflected in implied volatility values). ATM Options have the advantages of:

• Higher exercise probability than OTM Options.

• Relatively reasonable Option prices compared to ITM Options.

 

It should be noted that the time decay rate of ATM Options is higher than that of out-of-the-money (OTM) and in-the-money (ITM) Options when other factors are equal. Furthermore, when the market is volatile, the implied volatility of ATM Options might be significantly overvalued.

 

Given the shortcomings of ATM Options, when traders want to buy long-term puts to create a protective put strategy, OTM Options can also be considered for these three reasons:

 

1. For OTM Options with the same strike price, the delta of long-term Options is greater than that of short-term Options, which means long-term Options are more sensitive to asset price fluctuations than short-term Options.

2. The price of OTM Options is lower than that of ATM Options.

3. The time value of OTM Options decreases more slowly than that of ATM Options.

 

Exit Time

Since a protective put is not a self-executing risk management strategy, it’s important for traders to close their positions on time, especially when holding long-term Put Options — regardless of whether the Put Option positions are making profits or losses.