While day trading stocks can potentially lead to big profits, options are an ideal way to control a large chunk of shares without having to put up the funds necessary to own stocks of bigger companies and can actually help protect or hedge your stock investments.
This article will prepare you to effectively use the long put option strategy to generate a profit.
But before we dig a little deeper to explain, let’s begin by delving into the definition of an option and its different types.
What are Options?
Options are a type of derivative, meaning their value is dependent on the value of an underlying security.
The underlying security can be stock, but it can also be an exchange-traded fund (ETF), a commodity or an index.
An options contract is essentially an agreement between two parties that give the holder the right, but not the obligation, to buy or sell an underlying security (we assume stocks here) at a certain price (strike price) on or before the pre-agreed date “expiration date.”
Now that we have understood what options are, let’s look at what a put option is.
A put option is a type of option that gains value as a stock declines. Put option contracts give the owner the right, but not the obligation, to sell the underlying stock at the specified strike price at any point up until expiration.
They are typically bearish bets on the market, meaning that they profit when the price of an underlying security declines.
If the price of a stock is falling, a put option allows a seller to sell the underlying stock at the strike price and minimize risks.
The appeal of put options is that they can rise in value quickly on a small move in the stock price, and that makes them a favorite for individuals that are looking to make a big gain quickly.
The opposite of a put option is a call option.
Call option contracts gives the holder the right to buy the underlying stock at the specified strike price at any point up until expiration.
Long Put Option
A long a put option is a position in which a trader buys a put option contract thereby securing the right to sell the underlying stock at the strike price on or before the expiration date.
A trader is said to be “long a put option” when he has bought a put option and currently owns the put.
The term going long refers to buying a security (not selling one), and applies to any tradable security that a trader buys including put options. As stated earlier, a trader would buy long puts in anticipation of the price of the underlying stock falling in value.
For example, let’s assume stock ABC has price of $20 and you think the stock price is going to go down in the next few weeks. You could consider buying a $15 ABC put to profit from this expectation.
Let’s say that the premium for the put is $1.
Once you own the ABC $15 put option, you are said to be “long a put” on ABC. The seller of the ABC put option, from whom you bought it, is said to be “short a put.”
As a buyer you have to be careful of time decay. Options have an expiration so they lose value if the underlying price stays the same. This makes it hard for buyers because you have to be right on the price direction as well as when that move will happen.
One way to battle time decay (theta) is to buy further out expirations, which will give you more time. You will have to pay for more money for that time but sometimes it can be worth it.
Before you buy any put option in your stock trading adventures, you need calculate the breakeven price. Here is the formula to know whether your trade has potential to generate profit.
- Breakeven price = strike price + option premium cost
Therefore, if you are buying a $15 ABC put option that sells for a $1 premium, your break-even price would be
$15 + $1 = $16 per share
Profit and loss potential
The most that you can lose any time that you purchase an option is the premium that you paid for the option. This happens if the option is out-of-the-money upon expiration, in which case it expires worthless.
- Maximum loss = premium paid + commissions paid
In this example, you would lose the full $1 in premium if the stock closes upon expiration above $15, since the put would then be worthless.
The lowest level a stock can fall is $0. For a bearish trader buying a long put, the best-case scenario is that the stock drops to $0.
Under this scenario, you could exercise and sell the stock at the strike price, though the stock is worthless.
Difference Between Buying in and out-of-the-Money Puts
Like call options, put options can further be grouped into in-the-money put options and out-of-the-money put options.
A put option is considered in-the-money when the strike price is more than the current price of the security.
The put holder may exercise the option, selling the stock at the strike price. Or the holder can sell the put option to another buyer at fair market value.
On the other hand, a put option is said to be out-of-the-money if the strike price is less than the current market price.
Out-of-the-money puts offer greater reward potential than in-the-money puts but they are riskier.
An out-of-the money put would still have a price above $0 so long as it has not hit its expiry because there is always a possibility that the option can become in-the-money.
However, it is important to remember that you can be in-the-money but still losing money because the option price is greater than the profit you make from exercising the option.
The long put option strategy is great for traders who either don’t have the capital to short a stock or are wanting to hedge a long position.
Another benefit is they are leveraged so you can make big returns with little risk if you are right.
As a buyer, you have to pay attention to time decay. Buying further out expirations will give you more time but will also cost more.
Options are a great product to trade but it’s recommended to try them out in a simulator first so you can gain an understanding of their price action.