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Using a protective put strategy lets traders protect themselves against potential losses in an existing forex protective put position. This strategy can be used to hedge against significant currency pairs or stock price declines.
In this article, we will understand the protective put strategy in depth.
What is a protective put strategy?
A protective put strategy is used in options trading to protect a trader’s existing currency pair or stock position. In this strategy, a trader purchases a put option of a currency pair they already own. The put option gives the trader the right (but no obligation) to sell the currency pair at a predetermined currency pair or stock price (also known as the strike price) before the option contract expires.
What indicators can be used with the protective put strategy?
Volatility indicators
Volatility indicators measure market fluctuations, like the Volatility Index (VIX) or Average True Range (ATR). High implied volatility suggests purchasing a protective put is required to hedge against large price swings. Conversely, low implied volatility might indicate that the cost of the put option could be lower, and traders can avoid entering an options put contract.
Trend indicators
Trend indicators, like moving averages, help identify the currency pair’s trend direction. A protective put strategy can be adjusted based on the trend. For example, if the market trend is upward, traders might choose a put option with a lower strike price, whereas, in a downtrend, a higher strike price can offer better protection to the traders.
Momentum indicators
Momentum indicators, like the Relative Strength Index (RSI) or Stochastic Oscillator, provide traders with the trend strength and speed of forex price movements.
These help traders assess whether a currency pair is overbought or oversold. If momentum indicators suggest that the stock is overbought, it may be the right time to use a protective put to hedge against potential currency pairs or stock price declines.
Price action indicators
Price action indicators, like support and resistance levels or candlestick patterns, analyze a currency pair’s historical currency pair or stock price movements to predict future trends. They help traders determine optimal strike prices for the put options strategy. For example, if a currency pair is nearing a strong support level, purchasing a put option with a strike price just below this support can be the right move.
Option Greeks
Option Greeks, like Delta, Gamma, Theta, and Vega, provide insights into how the option’s price will change in response to various factors.
- Delta measures how much the option currency pair or stock price changes with the stock price movement. A higher Delta indicates greater sensitivity and vice versa
- Gamma measures the rate of change in Delta, helping traders understand how Delta can evolve
- Theta represents time decay, showing how the option’s value decreases as expiration approaches
- Vega measures sensitivity to changes in volatility
Advantages and risks of using the protective put strategy
Advantages
- Reduced downside protection: A protective put limits losses by allowing exit at a set price, providing a safety net during forex or stock price falls
- Unlimited upside potential: Traders can gain from rising markets while protected against losses, with gains reduced by the put option’s cost
- Hedging existing stock positions: Purchasing a protective put offers insurance against market drops, securing a hedge for existing forex or stock positions
- Precision in risk management: Protective puts offer precise control over maximum risk by setting specific strike prices, tailoring protection to individual trading needs
Risks
- Put option costs: High volatility can increase the cost of a put option, reducing overall net profits and impacting returns even with premium protection
- Limited effectiveness in uptrends: In strong uptrends, protective puts may offer limited gains as their value might not justify the cost if the market rises significantly
- Expiration risk: Put options expire, and if the market does not move significantly, the premium paid is lost, potentially decreasing overall gains
- Liquidity risk: Low liquidity in the options market can lead to higher costs or difficulties in executing trades
Step-wise guide to implementing the protective puts strategy
Evaluate risk and required protection
The first step for the trader is to determine the forex size potential and the potential downside risk the traders want to be protected against. The level of protection needed can be decided on the basis of risk tolerance and overall market outlook.
Choose strike price and expiration
Then, traders must select a particular strike price for the put option. This strike price should align with the trader’s protection goals and always be below the current market price.
Also, traders should only choose put options that provide them with enough time to cover their protection needs.
Purchase the put option and confirm the premium
Traders can purchase the put option after choosing the strike price and expiration trade. They must ensure the put option covers the same currency pair and quantity as the current forex or stock position.
Lastly, verify the cost (premium) of the put option and ensure it fits within the budget. The premium is the put price a trader pays for the protection.
Monitor asset and option performance
Trades must regularly monitor the performance of the protective put option and forex position. They must also check how the option’s value and the forex position are moving and whether the put option provides the intended protection.
Adjust the position as needed
If required, traders can purchase additional protective puts or exit existing ones at the current price to better align with their risk management needs.
Protective put vs covered call
A protective put involves purchasing a put option to hedge against losses in an existing forex or stock position, offering downside protection while allowing unlimited upside. In contrast, a covered call involves exiting a call option against a currency pair one owns, generating income but capping potential gains if the currency pair or stock price rises.
Placing forex orders even in a downtrend with a protective put strategy
A protective put strategy enables traders to manage volatile markets with downside risk protection. However, it also comes with significant costs, as premiums are paid with each put option. Evaluating the investment goals and market conditions will help determine whether this strategy aligns with a trader’s overall trading plan.
Disclaimer: All material published on our website is intended for informational purposes only and should not be considered personal advice or recommendation. As margin FX/CFDs are highly leveraged products, your gains and losses are magnified, and you could lose substantially more than your initial deposit. Investing in margin FX/CFDs does not give you any entitlements or rights to the underlying assets (e.g. the right to receive dividend payments). CFDs carry a high risk of investment loss.
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