Understand a Protective Put Strategy

This guide explains how a protective put works on Nifty, what it costs on one lot, how to choose the strike and expiry, how it compares with other hedges, and how to automate it.

At a glance

How a protective put works

A put option gives you the right to sell the underlying at the strike price until expiry. Held against a long position, it sets a floor:

• Below the strike, every rupee the position loses is matched by a rupee the put gains.
• Above the strike, the put expires worthless and the position keeps its gains.
• The premium is the cost of the floor, paid whether or not the market falls.

The combination of a long position and a long put has the same payoff shape as a long call: limited loss, unlimited gain.

The numbers on one lot

Suppose you hold a long position equivalent to one Nifty lot, 65 units at 25,000, worth ₹16.25 lakh. This could be a Nifty futures contract, a Nifty ETF holding or a portfolio that tracks the index. Using Black–Scholes model prices with 12 days to expiry and IV of 14%:

• Buy the 24,750 put at ₹128.70, a cost of ₹8,366 per lot, or about 0.5% of the position

The maximum loss is fixed at ₹24,616 per lot: the 250 points from 25,000 to the strike, plus the 128.70 premium, times 65. Without the put, a fall to 24,000 would cost ₹65,000.

A higher strike costs more and protects more

The ATM put caps the loss at the premium alone, but it costs almost twice as much. The OTM put is cheaper and leaves you with the first 250 points of any fall. The choice is the same as choosing an insurance deductible.

Choosing the strike and expiry

Strike

• At the money: full protection from the current level, at the highest cost.
• 5% out of the money: cheap, but covers only a large fall. Suits long-term holdings where you accept normal swings and want protection from a crash.
• 1% to 2% out of the money: a common middle ground for positions held through an event.

Expiry

Longer-dated puts cost more in total but less per day. A 40-day ATM put on Nifty costs about ₹470 per unit in the model, compared with ₹227 for 12 days: about 1.7 times the price for 3.3 times the cover. Buying one monthly put instead of four weekly puts is usually cheaper and avoids rolling.

Cost over a year

Rolling an OTM put every month costs several percent of the position a year. At 0.5% per 12 days, continuous protection would cost around 15% a year, more than the index's long-run return. A protective put makes sense for defined periods of risk, not as a permanent holding.

When a protective put works, and when it does not

Works best when:

• You want to hold a position through an event such as a budget, an election result or a central bank meeting.
• You have a large unrealised gain that you do not want to sell for tax or other reasons.
• IV is low, so the put is cheap relative to the risk.

Struggles when:

• The market drifts sideways. The premium is lost each period.
• IV is high. Puts bought after a fall are expensive.
• The position is small. Nifty's lot of 65 units protects about ₹16 lakh of exposure; a smaller portfolio is over-hedged.

Protective put vs other hedges

• A bear put spread sells a lower put to cut the cost, at the price of limited protection.
• A collar sells a call above the market to pay for the put. The call's premium covers most or all of the put, but it caps the gain.
• Selling futures removes the exposure altogether, with margin instead of premium.

Protective puts on stocks

Stock options on NSE can also protect individual holdings, with two differences:

• Lot sizes are large. A stock option lot can be worth ₹10 lakh or more, so the hedge only fits a sizeable holding.
• Physical settlement. In-the-money stock options settle by delivery of shares at expiry. If you hold the shares, a long put that expires in the money delivers them at the strike, which may be what you want. If not, close the put before expiry.

For a diversified portfolio, a Nifty put is usually the simpler hedge, sized by the portfolio's beta.

Automating a protective put

QuantPower can place the hedge on a rule rather than by hand:

1. In the strategy builder, set the condition, such as a date before an event, a fall below a moving average or a rise in India VIX.
2. Add a leg to buy a put at a strike 1% below the market in the nearest monthly expiry.
3. Add an exit rule, such as the day after the event or a close back above the moving average, to sell the put and stop paying for cover you no longer need.

Set a market alert on the strike level, and track the hedge and the position together in position monitoring.

Backtesting a protective put

The question a backtest answers is whether the cost of the puts was worth the losses they prevented. Compare the hedged and unhedged position over several years on:

• the maximum drawdown,
• the annual return after premiums, and
• the return per unit of risk, such as the Sharpe ratio.

Test the strike distance and whether to hedge continuously, around events only, or when a volatility filter triggers. Our guide on how to backtest trading strategies covers the method in detail.

Common protective put mistakes

• Buying protection after the fall. IV is then high and the put expensive.
• Hedging all the time. Continuous puts cost more than most portfolios earn.
• Letting the put expire in the money on a stock. Physical settlement delivers your shares.
• Mismatched size. One Nifty lot covers about ₹16 lakh; smaller portfolios need a smaller hedge or none.
• Forgetting the breakeven. The market has to rise by the premium before the position gains.

Frequently asked questions

Sources

• Black, F. and Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637–654
• NSE: Equity derivatives contract specifications
• SEBI circular SEBI/HO/MRD/DoP1/CIR/P/2018/161: Physical settlement of stock derivatives, 31 Dec 2018