Final answer:
A protective put strategy involves buying a put option on an underlying asset to protect against potential price decrease. The put option gives the holder the right to sell the asset at a predetermined price within a specified time. This strategy helps safeguard the value of the asset while allowing the investor to benefit from price increases.
Step-by-step explanation:
A protective put strategy is a risk management strategy used in financial markets. It involves buying a put option on a specific underlying asset, such as a stock or a commodity, with the intention of protecting against a potential decrease in the asset's price. The put option gives the holder the right, but not the obligation, to sell the underlying asset at a predetermined price, known as the strike price, within a specified period of time.
By purchasing a put option, the investor is essentially safeguarding the value of their asset in case the price goes down. If the price of the underlying asset decreases, the value of the put option will increase, offsetting the losses on the asset. On the other hand, if the price of the asset increases, the investor can simply let the put option expire or sell it at a lower price than the initial purchase price, limiting the loss to the premium paid.
For example, let's say an investor owns 100 shares of a stock with a current market price of $50 per share. They are concerned about a potential decline in the stock's price, so they decide to implement a protective put strategy. They purchase a put option with a strike price of $45 and an expiration date of one month. The premium paid for the put option is $2 per share, totaling $200. If the stock price drops to $40 per share, the put option will be in-the-money, and the investor can exercise the put option, selling the shares at the strike price of $45 per share instead of the lower market price of $40. This protects the investor from a larger loss.