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 investments, 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 position is initiated when a buyer purchases a put option contract. Puts are listed in an option chain and provide relevant information for every strike price and expiration available, including the bid-ask price. The cost to enter the trade is called the premium. Market participants consider multiple factors 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 exists 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 maximum risk is limited to the cost of the option. The profit potential is unlimited until the underlying asset reaches $0. To break even on the trade at expiration, the stock price must be below the strike price by the cost of the long put option.
For example, if a long put option with a $100 strike price 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 be below $95 at expiration 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). The call option purchase results in cash debited from the trading account.
- Buy-to-open: $100 put
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 a 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 (ITM) at expiration, the holder of the contract can choose to exercise the option and will sell 100 shares of stock at the strike price. If the long put option is out-of-the-money (OTM) at expiration, the contract will expire worthless and the full loss is realized.
Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. All else being equal, 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 option price goes down. Therefore, time decay, or theta, works against options buyers.
Implied volatility reflects the possibility of future price movements. Higher implied volatility results in higher priced options because there is an expectation the price may move more than expected in the future. As implied volatility decreases, the option price goes down. Options buyers benefit when implied volatility increases before expiration.
Long put positions can be managed during a trade to minimize loss. A single-leg long put option can be converted into a bear put debit spread.
If the stock price increases, a put option can be sold at a lower strike price to reduce the trade's risk. This decreases the overall cost of the original position and lowers the break-even price. However, the short put option limits the maximum profit potential to the spread width minus the debit paid.
For example, if a $100 put option was purchased for $5.00, a $95 put option could be sold. If the short put option collects $1.00 of credit, the maximum loss is reduced to $400. The max profit, however, is now capped at $100 if the stock reverses and closes below $95 at expiration. The break-even point is now $1.00 less than the original payoff diagram.
- Sell-to-open: $95 put
Long put positions can be adjusted to extend the time duration of the trade if the stock has not decreased before expiration. The ability to roll the position into the future allows the trade more time to become profitable, but will come at a cost because more time equates to higher options prices.
If an investor wants to extend the trade, the long put option can be rolled out by selling-to-close (STC) the current position and buying-to-open (BTO) an option at a future date. This will likely result in paying a debit and will add cost to the original position.
For example, a $100 put option with a November expiration date could be sold and a $100 put option could be purchased for December. If the original position cost $5.00, and was sold for $2.00, the net loss on the original position is $300 per contract. If the December option costs an additional $5.00, the overall debit of the position is now $8.00. Therefore, the max loss increases to $800 and the break-even point moves out to $92.
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 increases above the strike price, the call will experience a gain in value and help offset the loss of the long put. However, this adds cost to the original trade and widens the break-even price.
For example, if the original long put had a $5.00 debit, and a long call is purchased for an additional $5.00, the risk increases to $1,000 and the break-even points are extended.
- Buy-to-open: $100 call
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 profit potential is limited to the difference between the sale price of the short stock position and the call option premium paid.