As the name suggests, this strategy protects your already existing position. In this strategy a long position is taken in the underlying and to protect any downside a put option is also bought.
If the stock goes up, the profit potential is unlimited and the loss is limited to only the premium paid for the put option. If the stock goes down, the put option becomes in-the-money and results into profits.
A trader buys Infosys LTD shares at a price of 940 per share. At the same time he also buys a put option of strike 940 by paying a premium of 10 rupees. Let’s see the payoff diagram now.
|Infosys at Expiry (S)||Stock Payoff
(market price-buy price)
|Put Option Payoff
|Premium Paid||Net Payoff|
As seen in the above table when the stock goes down, put option helps in minimizing the loss to 10 rupees only.
If the payoff diagram is observed closely, it resembles payoff diagram of a long call option. Even in the call option, the maximum loss is only the premium paid. And if the underlying stock price goes up, the profit is unlimited. Similar is the case with protective put strategy.