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Long Put Option Trading Strategy Explained with Examples

What Is a Long Put?

Long Put OptionA long put option refers to an options trading strategy.  Typically, the trader anticipates a decline in the underlying asset. A trader could buy a put for speculative reasons.  He is 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.

Investors buy long put options if they think a security’s price will fall. Investors also may buy long put options to speculate or hedge a portfolio. In either case, the downside risk is limited using a long put option strategy.

Long Put Option Basics

A long put option has a strike price.  This is the price at which the put buyer has the right to sell the underlying asset. For example, 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. On the other hand, if the stock rises and remains above $50, the contract expires worthless.  This is because it is not practical to sell at $50 when the stock is trading at $60.

If a trader chooses to sell the underlying asset at the strike price, he can 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. (Source: investopedia.com)

Long Put Option Vs. Shorting Stock

A long put can 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.

The drawback to the put option is that the price of the stock 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. (Source: ibid)

In summary, it is more convenient to bet against a stock by purchasing put options.  This is because 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 worthlessly.

Long Put Option 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.

Hedge Example

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 options contract with a strike price of $20 for $0.10 (multiplied by 100 shares since each contract 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 options contract. 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.  (Source: ibid)

Long Put Option – Example 

Suppose the stock of ABC 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 ABC stock will fall in the coming weeks and so you pay $200 to purchase a single $40 ABC put option covering 100 shares.

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

However, let’s say you were wrong and the stock price instead rallied to $50.  In that case, your put option would expire worthlessly.  However, your total loss would be limited to the $200 that you paid to purchase the option.

Example 2

Let’s assume Apple Inc. (AAPL) is trading at $170 per share.  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.

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 options contracts would expire worthless, resulting in you losing your initial outlay cost of $450.

(Source: ibid)

Long Put Option Maximum Loss = Premium Paid

Any time that you purchase an option, the most that you can lose is the premium that you paid. This is true for both calls and puts. This even occurs if the option is out-of-the-money upon expiration, in which case it expires worthless.

Commissions

For ease of understanding, the calculations depicted in the examples do not take into account commission charges.  Typically, they are relatively small amounts (around $10 to $20) and vary across option brokerages. However, for active traders, commissions can eat into a sizable portion of their profits. If you trade options actively, it is wise to look for a low commissions broker.

Up Next: Day Trading For Beginners – What Is A Day Trader?

Day trading can be summarized simply as buying underlying security and quickly selling or closing out the position within a single trading day.  Ideally, a day trader wants to “cash-out” by the end of each day with no open positions to avoid the risk of losses by holding the security overnight.  Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term.  Short term profits require a very different approach compared to traditional long term, buy and hold investment strategies.

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