Short selling stock is not available for all investors as it requires borrowing stock and uses margin. Furthermore, as opposed to buying a long put, short selling has unlimited risk because the underlying asset has unlimited upside potential.
Long put options give the buyer the right, but no obligation, to sell shares of the underlying asset at the strike price on or before expiration. Because options are levered, each contract is equivalent to selling 100 shares of stock. An advantage of using a long put option is that less capital is required to own one contract than the cost of selling 100 shares of stock, and downside risk is limited to the option contract’s cost.
A long put is purchased when the buyer believes the price of the underlying asset will decline by at least the cost of the premium on or before the expiration date. Further out-of-the-money strike prices will be less expensive but have a lower probability of success. The further out-of-the-money the strike price, the more bearish the sentiment for the outlook of the underlying asset.
A long put trade is initiated when a buyer purchases a put option contract. Puts are listed in an option chain and provide relevant information regarding each option for every strike price and expiration available, including the bid-ask price. The cost to enter the trade is called the premium. Market participants take multiple factors into consideration to assess the value of an option’s premium, including the strike price relative to the stock price, time until expiration, and volatility.
Typically, put options are more expensive than their call option counterparts. This pricing skew is because investors are willing to pay a higher premium to protect against downside risk when hedging positions.
The payoff diagram for a long put is straightforward. The profit potential is limited to the underlying asset falling to $0, and the maximum risk is limited to the cost of the option. Entering a long put requires paying a debit and the amount paid is the most an investor can lose on the trade. To break even on the trade, the stock price must be below the strike price at expiration by the cost of the long put option.
For example, if a long put option with a strike price of $100 is purchased for $5.00, the maximum loss is defined at -$500, and the profit potential is unlimited until the stock reaches $0. However, the underlying stock must drop below $95 to realize a profit.
To enter a long put position, a buy-to-open (BTO) order is sent to the broker. The order is either filled at the asking price (market order) or at a specific price an investor is willing to pay (limit order). Once a put option is purchased, cash is debited from the trading account.
There are multiple ways to exit a long put position. Anytime prior to expiration, a sell-to-close (STC) order can be entered, and the contract will be sold at the market or limit price. The premium collected from the sale will be credited to the account.
If the contract is sold for more premium than originally paid, a profit is realized. If the contract is sold for less premium than originally paid, a loss is realized. If the long put option is in-the-money at expiration, the holder of the contract can choose to exercise the option and will sell 100 shares of stock per contract at the strike price.
Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. Options contracts with more time until expiration will have higher prices because there is more time for the underlying asset to experience price movement. As time until expiration decreases, the price of the option goes down. Time decay, or Theta, works against options buyers.
Implied volatility reflects the possibility of future price movements. Higher implied volatility results in a higher price of the option because there is an expectation the price will move more in the future. As implied volatility decreases, the price of the option goes down. Options buyers want to buy options when the expectation is implied volatility will be higher on or before expiration.
Long put options positions can be managed during a trade. Long put positions where the underlying security’s price moves away from the long put strike price can be adjusted to extend the trade’s time duration or converted to a risk-defined debit position to minimize loss. The ability to roll options positions into the future allows the trade more time to become profitable, but will typically come at a cost because more time equates to higher options prices.
If the stock price rises above the long put strike price, a put option can be sold at a lower strike price to decrease the trade’s maximum loss. For example, if a $100 put option is owned, a $95 put option can be sold. This will lower the overall cost to the original position and lower the break-even price. However, doing so will limit the maximum gain on the position.
If an investor wants to extend the trade, the long put option can be rolled out to future expiration dates. Rolling out the option requires selling-to-close (STC) the currently held position and buying-to-open (BTO) an option with the same strike price at a future date. Doing so may result in paying a debit and will add cost to the original position.
To hedge a long put, an investor may purchase a call with the same strike price and expiration date, thereby creating a long straddle. If the underlying stock price goes beyond the strike price, the call will experience a gain in value and help offset the loss in value of the long put. However, this adds cost to the original trade and will extend the break-even price.
Another strategy to hedge a long put is to sell a put below the original strike price to create a put debit spread. Adding the short put collects a credit and reduces the overall cost of the trade. However, this will limit the upside potential because the seller is obligated to buy shares at the lower strike price.
A synthetic long put combines short stock with a long call option at the strike price of the original short stock position. This creates a synthetic long put because the payoff diagram is similar to a single long put option. The maximum downside risk is limited to the strike price of the long call option, and the upside potential is limited to the difference between the sale price of the short stock position and the call option premium paid.