Hedging with Options: Protective Puts and Collars

Protective put: blocks only the bad side

Holding a stock and buying a put option at the same time is a protective put. Below the strike the loss is locked, while the upside is untouched. The cost is the premium, like an insurance premium.

Collar: trade upside for the premium

Also sell a call option with a higher strike, and the premium you collect can pay for the put. That's a collar. The outcome is locked into a range: a floor below, a cap above.

The premium is an ongoing expense

In the simulator, a 6-month put option with a $90 strike costs about $3. Renew it every six months and that's about $6 a year, giving up roughly 6% of return annually. Buying insurance all the time noticeably drags on long-term returns, so many people buy it only during the riskiest stretches, or use a collar instead.

Key takeaways

• Protective put = hold the stock + buy a put: below the strike your loss is capped and the upside stays open, at the cost of the premium.
• Collar = also sell a call with a higher strike, using the premium received to offset the put's cost, at the cost of giving up gains above that strike.
• A futures hedge locks both sides; an options hedge blocks only one. Flexibility costs money.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Click "Example: $90 put": if the stock falls to $70, how much does the stock lose? How much does the put make? What's the most you can lose in total?
2. Drag the price at expiry to $60, then to $85: did the total loss change? Why is it a flat line below $90?
3. Drag the put strike from $90 to $100: what does the premium become? What's the trade-off between the maximum loss and the premium?
4. Click "Zero-cost collar": what's the strike of the call you sell? Drag the stock to $135: what did you give up?

Quiz and explanations

1. Your stock cost $100 and you buy a $90-strike put for a $3 premium. What's the most you can lose per share at expiration?

Answer: $13.Below $90 the put catches the fall: the $10 drop + the $3 premium = $13.

2. What's the main purpose of selling the higher-strike call in a collar?

Answer: To offset the cost of buying the put with the premium received.Selling the call brings in money and buying the put costs money, so the two can come close to canceling out.

3. Your stock cost $100 and you bought a $90-strike put for a $3 premium. At expiration the stock is $120. What's your combined P&L per share?

Answer: +$17.The put expires worthless; the stock gains $20, minus the $3 premium, for +$17. The insurance went unused, so the premium is what it cost.

Terms in this lesson

• call option (Call): The right to buy the underlying at the strike price; the higher the stock goes, the more it's worth.
• collar (Collar): Holding stock + buying a lower-strike put + selling a higher-strike call, which locks the outcome in a range at close to zero cost.
• premium (Premium): The price of an option, paid by the buyer to the seller; it's the most the buyer can lose.
• protective put (Protective Put): Buying a put while holding the stock, like buying insurance against a price drop.
• put option (Put): The right to sell the underlying at the strike price; the lower the stock goes, the more it's worth.
• strike price (Strike): The price written into an option contract at which you can buy or sell.