Options trading can be both exhilarating and intimidating for beginners. One strategy that is known for its simplicity and potential profitability in bearish market conditions is the long put option strategy.
A long put option provides traders with a powerful tool to capitalize on a declining market. This strategy allows investors to profit from the decrease in the price of an underlying asset, making it a valuable addition to one’s arsenal, especially when anticipating bearish trends.
This article comprehensively explores what long put is and how it works.
What is a Long Put?
A long put, or put option, is a financial contract allowing the buyer to sell an asset at a set price before the expiry.
Unlike shorting puts, buying a long put gives the right, not the obligation, to sell. To initiate a long put position, a trader pays a premium upfront to the options writer, representing the maximum potential loss.
Long puts provide a defined risk advantage over short-selling, making them a valuable tool for investors seeking to profit from declining asset prices.
How Long Put Options Trading Strategy Work
A long put works by granting the buyer the right, without any obligation, to sell the underlying asset at the strike price. This allows them to make a profit if the asset’s price drops below the strike price.
To establish a long put position, a trader buys a put option contract for the desired underlying asset, paying an initial premium to the options seller. The premium represents the maximum potential loss in case the long put expires without value.
Source: Strike
The cost of the premium is influenced by factors such as the selected strike price, time until expiration, and implied volatility. Puts that are out-of-the-money are more affordable since they have a lower likelihood of becoming profitable before expiration.
In exchange for paying the premium, the holder of a long put option gains the right to sell 100 shares of the underlying asset per contract at the predetermined strike price until the option expires.
READ: How to Navigate Bear Markets and Volatility
The potential results of holding a long put position are:
Maximum profit – strike price – premium paid
The maximum profit is achieved when the price of the underlying asset drops to zero before the option expires. In this case, the holder of the put option sells the stock at a higher strike price. The ultimate reward is calculated as the difference between the strike price and the premium paid.
Maximum loss – premium paid
If the price of the asset remains higher than the strike at expiration, the long put option loses its value. The person who bought the put option restricts their maximum loss to the initial premium they paid.
Breakeven point – strike price – premium paid
To reach the breakeven point, the asset price must drop below the strike price minus the premium paid for the long put position. Holding until expiration is essential to turn a profit.
If the asset price falls significantly below the strike price, the put option gains intrinsic value.
The trader can then either exercise the right to sell at the strike price, securing an in-the-money profit or sell the appreciated long put option in the market for an early exit and gains.
It’s crucial to consider options’ time decay, known as theta, as their value diminishes nearing expiry due to decreasing time value. Traders manage this by making timely entries, exits, and rolling over positions to later expiries.
How to Set Up a Long Put
To open a long put position, a buyer acquires a put option contract from the option chain. This chain details all available strike prices and expirations, along with bid-ask prices. The entry cost is the premium.
Assessing the premium involves factors like the strike price compared to the stock, time until expiration, and volatility. Usually, put options cost more than calls due to investors paying a higher premium for downside protection when hedging positions.
Long Put Example
Suppose stock ABC is priced at $100, and an investor anticipates a decline. They might buy a put option at a 90-strike price for $2. If the stock falls to $85, they earn $5 on the 90 put.
After subtracting the $2 option cost, their net gain is $3. However, if the stock rises or never drops to $90, they incur a loss of the $2 investment.
READ: How to Use Ichimoku Cloud Strategy for Options Trading
Factors to Consider When Using the Long Put strategy
Here are the factors to consider when using the long put option strategy:
Potential position that could be created at expiration
Traders must assess the potential position resulting from holding options until expiration, as it dictates the profit or loss in a long put trade. Holding long puts until expiration can lead to unintended consequences, turning the position into a synthetic short stock if assigned.
For instance, if a trader buys a 3-month long put for a stock at $50 with a strike price of $45, and the stock drops to $40 at expiration, the $45 puts will be in the money with a $5 intrinsic value.
An uninformed trader might hold the puts, hoping for more profits. However, upon expiry, they would be assigned to sell the stock at $45, resulting in a $5 loss per share. This creates a synthetic short stock position at $40, potentially leading to further losses if the stock rebounds.
On the other hand, an experienced trader recognizes the $45 long put creates a synthetic short stock position at $45 and closes the position, booking profits rather than risking losses from an unfavorable short stock position.
Knowledge of holding in, at, or out-of-the-money long puts until expiry is crucial for maximizing profits and optimizing risk management.
Volatility changes
An increase in implied volatility is beneficial in a long put strategy. Increased volatility adds more time value to the put option, causing the value of existing long puts to rise. This allows traders to sell their puts at a higher market price, securing profits.
However, if volatility decreases after initiating long puts, the time value decreases, leading to a loss in the put’s premium. For instance, if a trader enters a long put position before an event causing high implied volatility, once the event passes, a rapid volatility drop results in quick time value decay.
Failing to consider this volatility contraction may lead to unexpected losses. Traders can minimize this risk by planning exits before anticipated drops in volatility post-events. On the other hand, if volatility sharply spikes, traders can strategically increase long put positions to leverage the amplified time value.
Swift adjustments in position size and pricing evaluation create a favorable risk-reward scenario. Traders that don’t adapt to volatility changes forfeit this benefit. Long-put traders should monitor historical and implied volatility, anticipate changes, model their impact on put valuations, and adjust positions and exits proactively.
Maximum profit
Traders need to consider the attractiveness of the risk-reward ratio compared to the maximum potential loss. This assessment helps identify if the trade offers a favorable opportunity.
The maximum loss for long puts is fixed at the premium paid for the options. However, the profit potential is unlimited if the underlying asset price drops to zero. Traders seek substantial gains in exchange for a known capital risk.
Analyzing the maximum profit also influences position sizing. A higher profit potential allows for a larger commitment of capital, enhancing position size and maximizing overall gains.
Time value
The time value, or extrinsic value, is a crucial part of an option’s premium, representing the excess over intrinsic value. Initially, the premium is entirely time value, indicating the potential for intrinsic value before expiry.
However, as time passes, especially in the last month, time decay increases.
For instance, a 6-month put might be valued at $4 due to its longer duration. Yet, close to expiry, its value can drop to $1, even with an intrinsic value of $2, due to time decay. This loss in time value limits potential profits.
Knowing time value helps set profit targets and exit points. Traders monitor time decay to avoid losing value as expiry nears. Exiting before rapid decay preserves time value and maximizes profits.
Conclusion
The long put strategy is a way for investors to bet on a stock’s decrease. However, it comes with the risk of losing the entire premium if the prediction is incorrect.
Unlike short-selling, where risks are unlimited due to the potential for the stock price to keep rising without bounds, owning puts allows traders to potentially earn more when the underlying price falls.
