Explain the concept of protective put options.

Protective put options are a type of financial derivative that provide investors with a form of insurance or protection against potential losses in the value of an underlying asset. This strategy involves purchasing a put option on a specific asset, such as a stock or commodity, which gives the holder the right, but not the obligation, to sell the asset at a predetermined price (known as the strike price) within a specified period of time (known as the expiration date).

The purpose of using protective put options is to limit the downside risk associated with owning the underlying asset. By purchasing a put option, the investor has the ability to sell the asset at the strike price, regardless of its current market value. This means that if the price of the asset declines, the investor can exercise the put option and sell the asset at the higher strike price, thereby minimizing their losses.

For example, let's say an investor owns 100 shares of a stock that is currently trading at $50 per share. Concerned about a potential decline in the stock's value, the investor decides to purchase a protective put option with a strike price of $45 and an expiration date of one month. This put option gives the investor the right to sell the stock at $45 per share within the next month.

If the stock price indeed declines to $40 per share within the specified time frame, the investor can exercise the put option and sell the stock at the higher strike price of $45 per share. This allows the investor to limit their losses to $5 per share, rather than experiencing the full decline in the stock's value.

However, it is important to note that protective put options come at a cost. The investor must pay a premium to purchase the put option, which is essentially an insurance fee. This premium is determined by various factors, including the current market price of the asset, the strike price, the expiration date, and the level of volatility in the market.

In summary, protective put options provide investors with a way to protect themselves against potential losses in the value of an underlying asset. By purchasing a put option, investors have the right to sell the asset at a predetermined price, thereby limiting their downside risk. However, this protection comes at a cost in the form of a premium, which must be paid upfront.