Long Put Option Explained
A long put option is the second most basic option contract that is traded. With this style of option contract you are expecting the underlying stock to make a dramatic move lower between now and expiration. With a long put option you have already agreed to sell the underlying stock at a predetermined price in the future, therefore if the stock is lower in the future you can theoretically buy the stock at the lower price and sell the stock to the other party in your transaction at the strike price of the option contract. This is one of the first and most elementary ways to profit from declining stock prices and is similar to shorting a stock, but requires much less capital upfront with less risk overall.
In this video, we’re going to be talking about one of the simpler strategies and some of the basic building blocks of options, and that is the long single put option. As always, we’ll start here with the market outlook for just a single put option.
A long put is an expectation that the price of a stock is going to drop. That’s the essence of what you want to do. This is different than if you short a stock. If you short a stock, you expect the market to drop, but you also have that risk when shorting stocks that the market could rise and rise significantly against your position.
With a long put, you have limited loss, so your losses are capped at the price of the option in which you buy. You can't lose any more money than what it cost you to get the contract. Compared to shorting shares outright, like I said, a put option gives the buyer the power of leverage.
And since one contract will control 100 shares of stock, so instead of shorting 100 shares of stock, just simply buy one put option. The whole idea here with a put option is that you want to profit from a decline in the value or price of the underlying stock.
Now, how to set it up? It's very easy to set up since it’s just a single leg order. You’re simply going to buy a put option with a strike price and expiration period that you desire. You can buy these front month, you can buy these a couple of months out, and you can buy them at virtually any strike price you want in and around the market price.
The more bearish you are on the stock, the further out of the money you're going to be when you buy the option. For example: If the stock is trading at 50, we could buy this out of the money 40, and we'd be expecting the stock to be dropping more than $10 for us to make money.
You can see how bearish we are. This option is going to be much cheaper. Now, let’s say that we are moderately bearish. We could have a stock that’s trading at 40 and buy an at the money put.
That’s going to cost us a little bit more money, but the stock doesn't have to drop as much from that point for us to start to make money. Again, the more bearish you are, the further out of the money you can go.
What's the risk? Well, the maximum loss, as I said, is limited. It's limited to just the amount of money that you paid for the option. If the option does expire worthless, in this case, if the stock stays flat or rises during the expiration cycle, then you will lose money unless you close out the trade early.
But again, the most you can lose is just the premium that you paid for the option, to begin with. Now, the profit potential of all long options is theoretically unlimited. For put options, it's unlimited to zero because a stock can't drop below the price of zero.
If the stock does drop to zero, though, then you make as much money as you can make on this option. Now, that rarely happens unless the stock goes bankrupt or something like that, but you will have the chance to make some significant gains if the stock does continue to fall.
Volatility does play a really big impact on long options, but it's actually in your favor. All other things being equal, increases in implied volatility (so just general volatility in the marketplace, not necessarily in the underlying stock) is going to boost the value of the option because there is a greater probability that the stock is going to swing into that profit zone.
Volatility is going to be good for your stock. Obviously, for put options, volatility is even better since volatility tends to correlate with falling stock prices. As the stock falls, that's great. Volatility increases, that’s also great.
These can be a real, real big money where if you do catch a stock right at the beginning of a downtrend. Time decay for these are going to hurt you since the passage of time decay is going to impact this strategy.
We know that options have a finite life and therefore, it’s kind of “make-it-or-break-it” with all long option contracts. The stock has to move quickly, and it’s got to move before your expiration period. It’s got to move into that profit zone before expiration.
If it doesn't, then it's going to start to decay in value because the time left to make money is running out. That value disappears, and then all that's left is the intrinsic value, and if the option is out of the money, then that becomes zero.
Breakeven points are very easy to calculate on these single leg options since it’s the building blocks of most strategies. All you’re going to do for a long put option is take the long put strike which in this case is going to be $40, and you're going to subtract the premium that you paid because you want to make back at least that premium and that gives you our breakeven point.
On this particular graph, we’d take 40 minus the 200, and that would give us our breakeven point or the point in which it crosses this zero barrier. After that, then you’re going to start making a net profit on the trade overall. Well, let’s look at an example real quick.
Let’s say the stock price is trading at $40, so right here where my cursor is. We’re going to buy one 40 put for $200. That's the cost of that option. That $200 is going to be a debit on the trade.
We’re going to outlay that money. We don’t get that money in. It’s a cost of buying the option, so we give it to the market. And that also becomes our max loss. We can't lose any more than that $200.
That’s the cost of the option. Now, the maximum profit here is unlimited. It can go all the way to zero. Obviously, that’s rare to happen, so don't count on it. But theoretically, you could have unlimited profits to the downside.
Some tips and tricks regarding long put options: Puts are great for hedging and protecting stock positions. Like I said, what is really good about puts is that they work well in down markets and down markets usually have volatility which also works well for put options.
It’s a double, or I guess twice as much protection as you would with anything else. You’re just shorting the stock. I do like puts when used for hedging or protecting a stock position.
You can use it on a multitude of different strategies, but I like out of the money puts for hedging. It’s important that you understand how a put works independently of everything else so that when you combine these with other options, you have different options strategy payout.
As always, go back through this video if you didn’t catch something or wanted to hear me say it again or check out some of our other videos to learn about different option strategies.
But it's important to understand how these single leg options work independently of everything else so that when they’re combined with different strategies, you can overlap the features.
Remember to focus on at the money or slightly out of the money put options when buying for speculation and deep out of the money options for hedging purposes.
Again, you don't want to buy those deep out of the money options even though they’re cheap. Cheap options don't have a high probability of making money. That's why they’re cheap because they're not worth anything.
If you’re going to make a speculative move and you think that the stock is going down, try to focus on some at the money or slightly out of the money options and then just get out of them quickly if they do create a profit.
Get out of the trade and take your profit as soon as you can see it. As always, I hope you guys enjoyed this video and thanks for watching. Take just two seconds here if you like the video and share it right below here on any of your favorite social networks with your friends, family or colleagues.
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