Although some option strategies are very risky, others are less risky than the simple purchase of common stock. Recognition of this fact has led regulators to look more favorably on the writing of covered call options by financial institutions. Regulatory acquiescence has not extended, however, to the purchase of what may be called a protective put option.
Purchasing a put on stock in its own portfolio entitles an institution to sell the stock at a specific price until a certain date. The institution thus reduces its gains from any possible price rise by the premium paid for the put. On the other hand, it is protected against price declines. Thus purchase of a protective put entails less risk and less expected return than purchase of stock alone.
Purchase of a protective put does not violate relevant legal standards, including those focusing on the performance of individual securities. As regards ERISA, the absence of explicit prohibitions in Section 404 suggests that the appropriate legal question is whether the pension manager has achieved an appropriate level of portfolio risk at a fair price, rather than whether the protective put falls into some disfavored category such as “speculative investments” or “wasting assets.”
This does not mean that purchase of a protective put is always appropriate. A money manager should compare purchasing a put with alternative ways of reducing risk. In doing so, he should consider such factors as the price variability of the common stock, the premium on the put and taxes.