Basic Options Strategies: Long Put

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Basic Options Strategies: Long Put
A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into more complex bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding put options.

Market Opinion?
Bearish

When to Use?
Purchasing puts without owning shares of the underlying stock is a purely directional strategy used for bearish speculation. The primary motivation of this investor is to realize financial reward from a decrease in price of the underlying security.

This investor is generally more interested in the dollar amount of his initial investment and the leveraged financial reward that long puts can offer than in the number of contracts purchased.

Experience and precision are key in selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the put purchased is the more bearish the strategy, as bigger decreases in the underlying stock price are required for the option to reach the break-even point.







Benefit
A long put offers a leveraged alternative to a bearish, or "short sale" of the underlying stock, and offers less potential risk to the investor. As with a long call, an investor who purchased and is holding a long put has predetermined, limited financial risk versus the unlimited upside risk from a short stock sale.

Purchasing a put generally requires lower up-front capital commitment than the margin required to establish a short stock position. Regardless of market conditions, a long put will never require a margin call. As the contract becomes more profitable, increasing leverage can result in large percentage profits.

Risk vs. Reward
Maximum Profit = Limited Only by Stock Declining to Zero

Maximum Loss = Limited to Premium Paid

Upside Profit at Expiration = Strike Price - Stock Price at Expiration - Premium Paid
(Assuming Stock Price Below BEP)

The maximum profit amount can be limited by the stock’s potential decrease to no less than zero. At expiration an in-the-money put will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the put. Whatever your motivation for purchasing the put, weigh the potential reward against the potential loss of the entire premium paid.

Break-Even-Point (BEP)?
BEP: Strike Price - Premium Paid

Before expiration, however, if the contract’s market price has sufficient time value remaining, the BEP can occur at a higher stock price.

Volatility
If Volatility Increases = Positive Effect

If Volatility Decreases = Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay?
Passage of Time: Negative Effect

The time value portion of an option’s premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.

Alternatives Before Expiration?
At any given time before expiration, a put option holder can sell the put in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option’s premium, or to cut a loss.

Alternatives at Expiration?
At expiration most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the end of trading on the option’s last trading day.

An alternative is to purchase an equivalent number of shares in the marketplace, exercise the long put and then sell them to a put writer at the option’s strike price. The third choice, one resulting in considerable risk, is to exercise the put, sell the underlying shares and establish a short stock position in an appropriate type of brokerage account.
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