The long put options strategy is basically the opposite of the long call options strategy. It’s a basic strategy that involves the trader buying put options in the belief that the price of the underlying asset will fall below the strike price before the expiration date.
Are Put Options Similar to Short Selling?
Buying puts is often compared to short selling, but there are some fundamental advantages to buying puts instead of shorting stock. For instance it’s more convenient to bet against a stock by purchasing put options as you don’t have to leverage the stock to short. Additionally, the risk is capped to the premium paid for the put options, as opposed to the unlimited risk when short selling the underlying stock outright.
The downside is, 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 the stock price can reach zero at expiration, the maximum profit possible when using the long put strategy is only limited to the strike price of the purchased put less the price paid for the option.
To calculate the profit potential for any given long put option, use the formula below.
- Profit Achieved When Price of Underlying = 0
- Profit = Strike Price of Long Put – Premium Paid
The risk to implementing the long put strategy is limited to the price paid for the put option no matter how high the stock price is trading at the expiration date.
The formula for calculating maximum loss is given below:
- Max Loss = Premium Paid + Commissions Paid
- Max Loss Occurs When Price of Underlying = Strike Price of Long Put
The underling price at which breakeven is achieved for the long put position can be calculated using the following formula.
- Breakeven Point = Strike Price of Long Put – Premium Paid
Lets look at the same trade as we did for the long call strategy; Amazon (AMZN) is trading at $40, a put option contract with a strike price of $40 expiring in a month’s time is priced at $2. You believe that AMZN stock will fall sharply in the next few weeks so you pay $200 to purchase a single $40 AMZN put option covering 100 shares ($2 x 100 = $200).
After a few weeks the share price of AMZN has dropped to $30. With the underlying stock priced at $30, your put option will now be in-the-money with an intrinsic value of $1000, since that’s how much money would be realized if you sold the stock at the market price. Since you paid $200 to purchase the put option, your net profit for the entire trade would be $800.
However, if you were wrong in your assessment and the stock price had instead rallied to $50, your put option would have expired worthless and your total loss will be the $200 that you paid to purchase the option.
For simplicities sake the above example doesn’t include commissions. Most options brokers typically charge commission for every option bought and sold. The amount you’re charged varies from broker to broker but it’s usually around $10 to $20.
If you’re an active trader you can find some specialist brokers that offer reduced commissions for frequent traders. A good example of this type of broker would be OptionsHouse who charge around $0.15 per contract if you trade over 10 contracts at a time.
As you can see the long put strategy is the other side of the trade to a long call strategy. If you’ve traded long calls you should have no problem understanding long puts.
Now you’ve covered long calls and long puts, so what’s next? Well now we can move on to some more complex strategies, but don’t worry we’ll take it step by step and before you know it you’ll be an accomplished options trader.