Long Put Trading Strategy

When to Use?

The best time to use this strategy is when you have a bearish outlook and you are expecting an asset to drop significantly in value in a fairly short time frame. Although you can still use it if you think the asset will drop in price over a longer period of time, the effects of time decay can have a negative impact on any profits you make as puts lose extrinsic value over time.

There are other strategies that are probably better if you are only expecting a small drop in value, but in theory the long put can be used whenever you have a bearish outlook. It can also be used for hedging strategy if you want to protect an asset that you own against a possible reduction in value.

Why Use the Long Put Strategy?

There are several reasons why you might choose to use this strategy. It's an excellent alternative to short selling a security for three primary reasons.

First, and this is perhaps the most attractive reason for using it, the power of leverage means that you can potentially make a much bigger return on your money. Second, your risk is limited to however much you invest upfront, unlike when you short sell a security and your potential losses are unlimited. Third, there are no margin requirements; all you need is some capital to make the investment at the outset.

This is also a simple strategy that's easy to understand, making it appealing to beginners and traders that don’t like to compli level and your position can easily be transformed into a different one if your outlook changes.

How to Implement the Long Put Strategy

The long put is about as straightforward as it gets. There's just one transaction involved: the purchase of puts on the relevant underlying security. You would purchase these contracts through your broker by using a buy to open order.

There are three particular factors that you need to decide upon when using this strategy; the strike of the options contracts, the expiration date of the contracts, and whether to buy European or American style contracts. There are no hard and fast rules when it comes to making these decisions, because they ultimately depend on your own preferences.

The strike you choose will affect two things: the price you have to pay and the potential profits you can make. Beginners are best advised to stick to buying at the money contracts (where the strike is equal to the current trading price of the underlying security), because this is a good middle ground. You could alternatively choose to buy out of the money contracts with a lower strike, or in the money contracts with a higher strike price.

Out of the money contracts are cheaper, but you will need the underlying security to fall further to make a profit than with at the money contracts. In the money contracts are more expensive, but they have a higher delta value which means their value will increase more rapidly in relation to a drop in the price of the underlying security.

Choosing an expiration date is really just a matter of deciding how quickly you think the underlying security will fall in value. If you are expecting a quick drop, then it would be logical to buy contracts that have a short time until expiration. If you are expecting the price to drop more slowly, then longer term contracts would be a better choice.

In terms of choosing either European or American style contracts, this ultimately comes down to whether you want pay a higher premium for the additional flexibility of being able to exercise at any point prior to expiration.

Potential Profits and Losses

Quite simply, this strategy returns a profit when the underlying security falls in value. The further the security falls in price the higher this profit will be, and there are two ways in which you can realize any profits made.

As the underlying security falls in price, the puts you own will go up in price and you can use the sell to close order to sell them at any time. This is the most common approach. Alternatively, you could buy the underlying security and then exercise to sell it at the strike price, but this is a more complicated method and will cost you more in commission fees.

You will lose money if the underlying security goes up in price or fails to fall below the strike of the options you own. The worst possible scenario is that the options you buy end up expiring worthless and you lose however much you invested them. If the expiration date is approaching and you don't believe they are going to be worth anything by expiration, you may be able to sell them and at least recover some money.

In any case, the maximum loss of the long put is the amount that you spend on buying the contracts at the outset.

Benefits & Drawbacks

The long put offers a number of distinct benefits, and there is little in the way of drawbacks. Probably the most significant advantage is the fact that you can make unlimited potential profits while limiting any potential losses. Because of leverage power, you can make much bigger returns on your investment than would otherwise be possible by short selling a security, and you don’t have to invest as much capital either.

This is an incredibly simple strategy, which is a big advantage for beginners and those that don’t like having to work out complicated calculations. The fact that only one transaction is involved means low commission charges, and there are no margin requirements. All of these benefits make this a sound strategy.

The biggest drawback is that you are offered no protection if the underlying security increases in price, and you are exposed to losing all of your upfront investment if the security doesn't fall as expected. You will also suffer from the negative effect of time decay, which causes the extrinsic value of contracts to reduce in value over time, particularly as expiration approaches.

Example

Below you will find a simple example of using the long put. Please note that the purpose of this example is merely to illustrate how it works and doesn't necessarily contain any precise calculations. Commission costs have been ignored for this example.

Initial Trade

• Company X stock is trading at $50, and you expect it to fall in price.
• At the money puts on Company X stock (strike price $50) are trading at $2.
• You purchase 1 put options contract (containing 100 shares) for an investment of $200.

If Company X stock falls to $48 by expiration

At the time of expiration, the puts will be worth approximately $2 due to their intrinsic value. You could therefore sell them for around $200, meaning you will break even on the trade.

If Company X stock falls to $45 by expiration

In this scenario the puts will be worth around $5, meaning you could sell them for $500. This would give you a profit of $300 from a $200 investment.

If Company X Stock increases or is still at $50 by expiration

The options would expire worthless, and you would lose your initial $200 investment.

It's worth pointing out that you are under no obligation to keep hold of your options all the way until expiration. If they go up in price and you want to take your profit at any point then you can sell them whenever you want. You can also sell them if they start to go down in price and you want to cut your losses.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited only by how far the underlying security can fall in price.
• Profit is made when “Price of Underlying Security < (Strike Price - Price of Option)”
• Profit per option owned is “(Strike Price – Price of Underlying Security) – Price Of Option”
• Maximum loss is limited
• Maximum loss is made when “Price of Underlying Security > or = Strike Price”
• Maximum loss per option owned is “Price of Option”
• Break-even point is when “Price of Underlying Security = (Strike Price – Price Of Option)”

Summary

If you are expecting a security to fall in price by a significant amount, and quickly, then this is a good strategy to use. The simplicity makes it ideal for beginners, or those that are new to speculating on the price of a security going down rather than up. The long put offers great potential for profits and yet limited risk. You can only lose the amount that you spend on buying options.