What Is a Protective Put Option?
A protective put option is a risk-management strategy using options contracts that investors use to guard against the loss of owning cryptocurrency. Put options by themselves are a bearish strategy, where the trader believes the asset price will decline in the future. However, investors can use a protective put option when they are still bullish on a stock but wish to hedge against potential losses and uncertainty.
Potential Scenarios with Protective Put Options
A protective put option keeps downside losses limited while preserving potentially unlimited gains to the upside. However, the strategy involves being long on the underlying cryptocurrency.
If the underlying cryptocurrency price keeps rising, the investor does not need the protective put option, and it will expire with no value. All that will be lost is the premium paid to buy the put option.
Conversely, if the price continues to fall, the gains from the put option will hedge out the losses from the underlying cryptocurrency position.
Real-World Example of a Protective Put Option
For example, an investor purchased one BTC at $40000, then the price increased to $42000, giving the investor $2000 in unrealized gains. (An unrealized gain is an increase in the value of an asset, that has yet to be sold for cash.)
The investor does not want to sell because the price of BTC might rise higher. He also does not want to lose the $2000 in unrealized gains. The investor can purchase a put option to protect the profit made so far.
The investor buys a BTC put option with a strike price of $41500 for $200, which creates a worst-case scenario of selling BTC for $41500. The put option expires in three days. If BTC falls back to $40000, the investor gains on the put option.
The option premium cost is $200. As a result, the investor has locked in a minimum profit equal to $1300 ($41500 strike price - $40000 purchase price - premium = $41500- $40000- $200= $1300)
If the investor didn't buy the protective put option and the BTC price fell back to $40000, there would be no profit.
On the other hand, if the investor bought the put and the BTC price rose to $43000, there would be a $2800 gain on the trade. ($43000- $40000- $200= $2800)
What is a Strangle?
A strangle is an options strategy in which the investor holds a position in both a call and a put option with different strike prices but with the same expiration date and underlying asset. A strangle is a good strategy if you think the underlying security will experience a substantial price movement soon but are unsure of the direction. However, it is profitable mainly if the asset swings sharply in price.
How does a strangle work?
In a Strangle options strategy, the investor simultaneously buys an out-of-the-money call and an out-of-the-money put option. The call option's strike price is higher than the current market price of the underlying asset, while the put has a strike price lower than the asset's market price. This strategy has significant profit potential since the call option has theoretically unlimited upside if the underlying asset rises in price. If the underlying asset falls, the put option can profit. The trade risk is limited to the premium paid for the two options.
Example of a Strangle
To illustrate, let's say BTC is currently trading at $40000. A trader opens two options positions to employ the Strangle options strategy, a call and a put. The call option has a strike of $42000, and the premium is $300. The put option has a strike price of $38000, with a $285 option premium. Both options have the same expiration date.
If the price of BTC stays between $38000 and $42000 throughout the option's life, the loss to the trader will be $585, which is the total cost of the two options ($300 + $285).
If the price of BTC hits $37000, the call option will expire without value, with the $300 premium paid for that option lost. However, the put option expires with a gross profit of $1000 and a net profit of $715 (because $1000 minus $285 is $715). Therefore, the total gain to the trader is $415 ($715 in profit minus a $300 loss).
If the price rises to $42500, the put option expires without value and loses the premium paid for it of $285. The call option brings in a profit of $200 (a gross profit of $500 minus the $300 cost). When we factor in the loss from the put option, the trade incurs a loss of $85 ($200 in profit minus the $285 premium) because the price move wasn't large enough to compensate for the cost of the options.
The essential concept of a Strangle strategy is the move being big enough. If BTC had risen $4000 in price to $44000, the total gain would have been $1415 ($2000 gross profit - $300 call option premium - $285 expired put option premium).
Both strategies have their own advantages. To make money through strategies, you need to master the logic of strategy application before you can use strategies well.