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The buyer of put options has limited risk over the life of the option, regardless of the movement of the underlying assetLONG PUT In the long put strategy, you are purchasing the right, but not the obligation, to sell the underlying stock at a specific price until the expiration date. This strategy is used when you anticipate a fall in the price of the underlying shares. A long put strategy offers limited profit potential (limited because the underlying asset can fall no further than zero) and limited downside risk. It is often used to get high leverage on an underlying security that you expect to decrease in price. If you want to go long a put, your risk curve would look like the graph in Figure 4.14. Note how the profit/loss line for a long put strategy slopes upward from right to left. When the underlying instruments price falls, you make money; when it rises, you lose money. Note how the profit on a long put is limited as the price of the underlying asset can only fall to zero. The long put strategy is often used to get high leverage on an underlying security that is expected to decrease in price. It requires a fairly small investment and consists of buying one or more puts with any strike and any expiration. The buyer of put options has limited risk over the life of the option, regardless of the movement of the underlying asset. The put option buyers maximum risk is limited to the amount paid for the put. Profits are realized as the put increases in value as the underlying assets value falls. Buying a put is a limited-risk bearish strategy that can be used instead of shorting stock. It is best placed when the option is exhibiting low implied volatility. Keep in mind that the further away the expiration date is, the higher the premium. But the cost that time contributes to a put premium must be balanced out by the need for sufficient time for the underlying shares to move into a profitable position. Long Put Mechanics Lets create an example by going long 1 January XYZ 50 Put @ 5. The cost of this position is $500 (5 100 = $500) plus commissions. The maximum risk for this trade is limited to the premium of the put option while the reward is limited to the downside until the underlying asset reaches zero. Looking at the risk graph in Figure 4.14, notice how potential profit and loss values correspond to underlying share prices. Can you see the breakeven point? The breakeven is calculated by subtracting the put premium from the put strike price. In this trade, the breakeven is 45 (50 - 5 = 45), which means that XYZ would have to fall below 45 for the trade to start making a profit. Exiting the Position Choosing an exit strategy depends on the movement of the underlying shares as well as changes in volatility. XYZ falls below the breakeven (45): Either offset the long put by selling a put option with the same strike and expiration at an acceptable profit or exercise the put option to go short the underlying market. You can hold this short position or cover the short by purchasing the shares back at the current lower price for a profit. XYZ rises above the breakeven (45): You can wait for a reversal or offset the long put by selling an identical put option and using the credit received to mitigate the loss. The most you can lose is the initial premium paid for the put. In this example, lets say the price of XYZ falls from $50 to $40. This results in a rise in the premium of the October 50 put to 13.75. You now have a decision to make. To exit a long put, you can offset it, exercise it, or let it expire. To offset this position, you can sell the March 50 put and reap a profit of $875: (13.75 - 5) 100 = $875. If you choose to exercise the position, you will end up with a short position of 100 shares of XYZ at $50. This would bring in an additional credit of $5,000 (minus commissions). However, you would then be obligated to cover the short sometime in the future by purchasing 100 shares of XYZ at the current price. If you covered the short with the shares priced at $40, you would make a profit of $500: (5,000 - 4,000 = $1,000 for the stock minus $500 for the cost of the put). Therefore, offsetting the option yields a higher profit. In fact, you almost never want to exercise an option with time value remaining because it will be more profitable to simply sell the option. In addition, exercising the long put requires enough money in your trading account to post the required margin to short the shares. Long Put Strategy: Buy a put option. Market Opportunity: Look for a bearish market where you anticipate a fall in the price of the underlying below the breakeven. Maximum Risk: Limited to the price paid for the put option premium. Maximum Profit: Limited below the breakeven as the stock price can only fall to zero. Breakeven: Put strike price - put premium. Margin: None. Long Put Case Study A long put involves the purchase of just one option strike and one expiration month. Buying a long put is a strategy that benefits from a decline in the underlying security. However, unlike selling stock short, there isnt a need to use margin and entering the put is an easy process. As with any long debit strategy, a long put will suffer from time decay, so we want to use options that have at least 60 days, and preferably more, until expiration. By entering a long put, we have limited our risk to the initial cost of the put. At the same time, we have limited reward to the downside as the underlying can only fall to zero. Lets go back to the fall of 2000 and see how entering a put on the Nasdaq 100 Trust (QQQ or Qs) would have worked following a triple top formation. The Qs moved above 100 on August 31, but then formed a bearish pattern on September 1. At this time, it seemed that a break back below 100 would be bearish for the Qs. Thus, on September 5, an option trader could have entered a long put when the Qs closed at $99.50. The December 100 puts could be purchased for $8 each. Our maximum risk would then be $4,000 if we were to buy five contracts. Figure 4.15 shows the risk graph for long puts on the Qs. The risk graph shows that as the Qs fall, the puts increase in worth. Of course, if this trade were to be held until expiration, the price of the Qs would need to be below 92 to make a profit. However, the quicker the Qs drop, the larger the profit in the near term. In order to see a double in this trade, a move to about 85 would need to occur. At the close of trading the very next day (September 6), these puts were worth $9.38, a gain of nearly $700 in one day. The Qs continued to fall during the next several months, leading to a sharp decline for security, but a large increase in the long puts. Selling continued after the Qs fell Long Put Case Study Strategy: With the security trading at $99.50 a share on September 5, 2000, buy 5 December 100 puts @ 8.00 on the Nasdaq 100 Trust (QQQ). Market Opportunity: Expect decline in shares following bearish chart pattern. Maximum Risk: Limited to initial debit of $4,000. Maximum Profit: $46,000 if Qs were to go to zero. In this case, the puts increased to $17 each for a profit of $4,500. Breakeven: Strike minus the initial cost per put. In this case, 92: (100 - 8). Margin: None. through their 200-day moving average and were unable to recapture this prior support level. On the close of trading October 3, 2000, the Qs were at 84 and the puts were now selling for $17 each. At this time, the long puts could have been sold for a profit of $4,500: [(17 - 8) 5] 100 = $4,500. |
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