In the previous chapter, we’ve talked about long call, a commonly used options trading strategy.
Today we’ll touch on the second one: long put.
If you expect the price of a stock to fall, you could either short sell it, or buy its put options. Short selling is to sell the borrowed shares first and buy them back later.
The difference between the selling price and the buying price, less the interest paid, is the profit made from this short sale.
But short selling is more risky and costly than buying stock.
On the one hand, short selling requires minimum funding of the margin account. If you fail to meet the minimums, your broker may be forced to close your positions to control risks. On the other hand, the share price can rise instead of fall. For example, if you short sell a stock at $1,000, it may cost you thousands of dollars or more to buy back the shares.
So the unlimited potential loss is the riskiest part of short selling.
However, put options may offer investors some flexibility.
First, options can provide leverage because they could be much cheaper to purchase in comparison to the actual stock.
Moreover, as buying a put opens a long position, the maximum potential loss is limited to the premium paid.
So when buying a put, traders are able to limit their losses.
Still, options are a complex financial instrument. It doesn’t fit all investors as it requires accurate judgment about market trends and timing.
Now let’s look at the key takeaways about the long put strategy.
Here’s an option chain. Let’s take a put with a strike price of $52 and a premium of $1.89 per contract as an example.
An option contract generally represents 100 shares of the underlying stock. So you’ll need to pay $189 ($1.89×100) to get this put. This is its Profit & Loss (P/L) diagram.
The worst-case scenario for a long put is that the stock price doesn’t fall below the strike price, making the option expire worthless. In this case, your maximum loss will be the premium you paid.
In this course, let’s leave out commissions and other fees for illustration purposes to make things easier.
If the stock price goes below the strike price, the put option will have intrinsic value, which is the difference between the strike price and the stock price. But if the stock price doesn’t fall that much, you’ll still lose money because you’ve paid the premium to buy the put.
In other words, the break-even point for a long put is the strike price less the premium paid.
If the stock price falls below the break-even point, you’ll make a profit.
However, since it’s theoretically impossible for a stock to plunge into negative, the maximum profit for buying a put is the strike price less the premium paid.
To summarize, we can break down the risk profile of a long put into three scenarios:
1. If the stock price is greater or equal to the strike price, the option will expire worthless. Therefore, the maximum loss is the premium you paid.
2. If the stock price is less than the strike price but greater than the break-even point, you’ll still suffer some losses as the option’s intrinsic value is not enough to cover the premium you paid.
3. But if the stock price is less than the break-even point, which means that the option’s intrinsic value exceeds the premium paid, you’ll make a profit. However, just like short selling a stock, the maximum profit is limited because the stock price cannot become negative.
There’s one thing to remember: options contracts do not have to be held to expiration.
Time is key to an option’s value. In general, the closer we are to expiration, the less the time value.
Okay, so much for today’s long put strategy.
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