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|
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.
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:
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:
The underlier price at which break-even is achieved for the long put position can be calculated using the following formula.
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.
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).
The following strategies are similar to the long put in that they are also bearish strategies that have unlimited profit potential and limited risk.
Going long on out-of-the-money puts maybe cheaper but the put options have higher risk of expiring worthless.
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