Long Put Explained

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Long Put

What Is a Long Put?

A long put refers to buying a put option, typically in anticipation of a decline in the underlying asset. A trader could buy a put for speculative reasons, betting that the underlying asset will fall which increases the value of the long put option. A long put could also be used to hedge a long position in the underlying asset. If the underlying asset falls, the put option increases in value helping to offset the loss in the underlying.

Key Takeaways

  • Investors go long put options if they think a security’s price will fall.
  • Investors may go long put options to speculate or hedge a portfolio.
  • Downside risk is limited using a long put options strategy.

The Basics of a Long Put

A long put has a strike price, which is the price at which the put buyer has the right to sell the underlying asset. Assume the underlying asset is a stock and the option’s strike price is $50. That means the put option entitles that trader to sell the stock at $50, even if the stock drops to $20, for example. On the other hand, if the stock rises and remains above $50, the option is worthless because it is not useful to sell at $50 when the stock is trading at $60 and can be sold there (without the use of an option).

If a trader wishes to utilize their right to sell the underlying at the strike price, they will exercise the option. Exercising is not required. Instead, the trader can simply exit the option at any time prior to expiration by selling it.

A long put option may be exercised before the expiration if it’s an American option whereas European options can only be exercised at the expiration date. If the option is exercised early or expires in the money, the option holder would be short the underlying asset.

Long Put Strategy Versus Shorting Stock

A long put may be a favorable strategy for bearish investors, rather than shorting shares. A short stock position theoretically has unlimited risk since the stock price has no capped upside. A short stock position also has limited profit potential, since a stock cannot fall below $0 per share. A long put option is similar to a short stock position because the profit potentials are limited. A put option will only increase in value up to the underlying stock reaching zero. The benefit of the put option is that risk is limited to the premium paid for the option.

The drawback to the put option is that the price of the underlying must fall before the expiration date of the option, otherwise, the amount paid for the option is lost.

To profit from a short trade a trader sells a stock at a certain price hoping to be able to buy it back at a lower price. Put options are similar in that if the underlying stock falls then the put option will increase in value and can be sold for a profit. If the option is exercised, it will put the trader short in the underlying stock, and the trader will then need to buy the underlying stock to realize the profit from the trade.

Long Put Options to Hedge

A long put option could also be used to hedge against unfavorable moves in a long stock position. This hedging strategy is known as a protective put or married put.

For example, assume an investor is long 100 shares of Bank of America Corporation (BAC) at $25 per share. The investor is long-term bullish on the stock, but fears that the stock may fall over the next month. Therefore, the investor purchases one put option with a strike price of $20 for $0.10 (multiplied by 100 shares since each put option represents 100 shares), which expires in one month.

The investor’s hedge caps the loss to $500, or 100 shares x ($25 – $20), less the premium ($10 total) paid for the put option. In other words, even if Bank of America falls to $0 over the next month, the most this trader can lose is $510, because all losses in the stock below $20 are covered by the long put option.

Real World Example of Using a Long Put

Let’s assume Apple Inc. (AAPL) is trading at $170 per share and you think it’s going to decrease in value by about 10% ahead of a new product launch. You decide to go long 10 put options with a strike price of $155 and pay $0.45. Your total long put options position outlay cost is $450 + fees and commissions (1,000 shares x $0.45 = $450).

If the share price of Apple falls to $154 before expiry, your put options are now worth $1.00 since you could exercise them and be short 1,000 shares of the stock at $155 and immediately buy it back to cover at $154.

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Your total long put options position is now worth $1,000 – fees and commissions (1,000 shares x $1.00 = $1,000). Your profit on the position is 122% ($450/$1,000). Going long put options allowed you to realize a much greater gain than the 9.4% fall in the underlying stock price.

Alternatively, if Apple shares rose to $200, the 10 option contracts would expire worthless, resulting in you losing your initial outlay cost of $450.

Long Put

The long put option strategy is a basic strategy in options trading where the investor buy put options with the belief that the price of the underlying security will go significantly below the striking price before the expiration date.

Long Put Construction
Buy 1 ATM Put

Put Buying vs. Short Selling

Compared to short selling the stock, it is more convenient to bet against a stock by purchasing put options as the investor does not have to borrow the stock to short. Additionally, the risk is capped to the premium paid for the put options, as opposed to unlimited risk when short selling the underlying stock outright.

However, put options have a limited lifespan. If the underlying stock price does not move below the strike price before the option expiration date, the put option will expire worthless.

“Unlimited” Potential

Since stock price in theory can reach zero at expiration date, the maximum profit possible when using the long put strategy is only limited to the striking price of the purchased put less the price paid for the option.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying = 0
  • Profit = Strike Price of Long Put – Premium Paid

Limited Risk

Risk for implementing the long put strategy is limited to the price paid for the put option no matter how high the stock price is trading on expiration date.

The formula for calculating maximum loss is given below:

  • Max Loss = Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying >= Strike Price of Long Put

Breakeven Point(s)

The underlier price at which break-even is achieved for the long put position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Long Put – Premium Paid

Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You believe that XYZ stock will fall sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were proven right and the price of XYZ stock crashes to $30 at option expiration date. With underlying stock price now at $30, your put option will now be in-the-money with an intrinsic value of $1000 and you can sell it for that much. Since you had paid $200 to purchase the put option, your net profit for the entire trade is therefore $800.

However, if you were wrong in your assessement and the stock price had instead rallied to $50, your put option will expire worthless and your total loss will be the $200 that you paid to purchase the option.

Note: While we have covered the use of this strategy with reference to stock options, the long put is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the long put in that they are also bearish strategies that have unlimited profit potential and limited risk.

Buying Index Puts

The index long put is the simplest strategy to use in index options trading and the implementation involves the purchase of an index put option.

Index Long Put Construction
Buy 1 ATM Index Put

The options trader employing the index long put strategy believes that the underlying index level will fall significantly below the put strike price within a certain period of time.

Unlimited Profit Potential

Since they can be no limit as to how low the index level can be at the option’s expiration date, there is no limit to the maximum profit possible when implementing the index long put strategy.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Index Settlement Value

Limited Risk

Risk for the index long put strategy is capped and is equal to the price paid for the index put option no matter how high the index is trading on expiration date.

Breakeven Point(s)

The underlier price at which break-even is achieved for the index long put position can be calculated using the following formula.

  • Breakeven Point = Index Put Strike Price – Premium Paid

Example

XYZ Index is a broad based index representative of the entire stock market and its value in June is 400. Believing that the broader market will retreat in the near future, an options trader purchases an six-month XYZ index put with a strike price of $400 expiring in December for a quoted price of $4.00 per contract. With a contract multiplier of $100, the cost of the index put option comes to $400.

Suppose XYZ Index dropped to 380 in December and the trader’s DEC 400 XYZ index put expires in-the-money. At settlement value of 380, the DEC 400 XYZ index put option will have an intrinsic value of $20 and exercising this option will give the trader a settlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the cost of the option itself, which is $400, the trader’s net profit comes to $1600.

Suppose XYZ Index went up to 420 in December and the trader’s DEC 400 XYZ index put expires out-of-the-money. At settlement value of 420, the DEC 400 XYZ index put option will expire worthless with zero intrinsic value. The trader’s net loss is equal to the amount paid for the index put option which is $400.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Out-of-the-money Index Puts

Going long on out-of-the-money puts maybe cheaper but the put options have higher risk of expiring worthless.

In-the-money Index Puts

In-the-money puts are more expensive than out-of-the-money puts but less amount is paid for the option’s time value.

Portfolio Insurance

Index puts can also be used to protect a portfolio against a declining market without the need to liquidate any stock while at the same time enable the portfolio to participate and benefit from a rising market.

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