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A protective put is a policy that enables investors to shield against loss regardless of how a financial vehicle’s value changes. This is not a free option. An investor must pay for a protective put, and the cost is relative to the amount of money he wants to protect. The policy only comes into effect if the financial vehicle drops in value; if the value goes up, then the investor only loses what he paid for the protection. Investors are protected because, if the value of the vehicle changes, the protective put policy will pay for the amount lost.
When someone purchases a financial vehicle, the vehicle’s value can increase, decrease or stay the same, though it typically will rise or fall. Most investors do not have any qualms about an increase, but a decrease can cause major losses. There are a few ways to shield from losses, and a protection put policy is one of them. This will place a cap on the total amount of loss investors experience if the vehicle falls in price.
While a protective put is a useful option for investors, it is not free and it will eat into investors’ profits a bit. The price of the policy is determined by factors such as risk and the exact financial vehicle, but it mostly is determined by the value of the financial vehicle and the amount of protection investors want. Even if investors do not benefit from the protection, because the value of their investment increases, the loss usually is nominal and is much better than the loss tied to the investment’s value decreasing.
A protective put can only be used if an investment’s value decreases. If the value increases, then the policy does not do anything to limit growth, outside of the policy’s initial costs. At the same time, because the protection costs money, the investor should not sell or trade the investment vehicle until the value surpasses the price of the protection; otherwise, the investor will lose money.
To protect an investor, a protection put can be traded up to a certain value based on what the investor has lost. When the investor loses on an investment, the policy protects the investor by paying for part or all of the loss, depending on the policy, but it will not pay more than the losses. For example, if the policy is worth $2,000 U.S. Dollars (USD) and the investor loses $500 USD on his investment, then the policy will pay the $500 USD, not $2,000 USD.