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
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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