The long put options trading technique grants the right to sell an underlying stock at the set price, point A, as shown on the graph. When a put option is purchased, the investor is betting that the stock will fall below the strike price before the expiration date.
Using a put instead of shorting the stock decreases the investor’s risk because they can only lose the cost of the put, as opposed to the limitless risk of shorting the stock.
- If the stock increases, the long put option will expire worthless, leaving the holder with merely the option’s cost. Similarly, an investor who shorted the stock will continue to lose money as the company rises in value.
- When purchasing puts, especially short term, there is a need for investors to be careful. If an investor buys many put contracts, their risk also increases. This is because the options can expire worthless, whereby the investor would lose the entire investment.
When Should You Purchase Put Options?
- Put option contracts can be purchased for a variety of reasons, including speculation (the investor believes a stock’s price will decline).
- A long put can also be used as a hedge against existing stock to protect an asset against a rapid drop in value, often known as a protective put.
If the stock that is already held suddenly drops in value, owning a put option would increase in value, offsetting the stock’s losses.
Purchasing a Put Versus Shorting the Stock
Shorting the stock and purchasing put option contracts are the most popular tactics for investors who want to take a bearish position in the firm.
Shorting a stock is a risky endeavour because a stock’s price might climb indefinitely, resulting in endless risk. Buying a put is an alternate bearish approach because an investor can only lose the cost of the put, therefore the risk is restricted.
However, purchasing a put option allows you to profit from a stock’s downward movement while limiting your risk to the premium paid for the option contract.
Profit/Loss
Maximum Loss = Net Premium Paid
The maximum gain for a long put strategy is limitless because the stock can continue to fall in value until it reaches zero.
Breakeven
- A long put option’s breakeven point is derived by subtracting the premium from the strike price.
- If a stock is now selling at Rs.100 and an investor wishes to purchase a 90-strike price put for Rs.2.0, the breakeven point is Rs.88.00.
Example
If stock XYZ is trading at Rs.100 and the investor believes it will fall, he may purchase a Rs.2 put option with a strike price of 90.
If the price falls to Rs.85, they will make Rs.5 on the 90 put, but because the option cost Rs.2, their net gain will be Rs.3.
However, if the stock continues to rise or never falls below Rs.90, they would lose their Rs.2 investment.
Conclusion
The long put is an investment strategy that allows the investor to bet on the stock’s decline. The investor must be prepared to lose the entire premium if they are incorrect.
When the underlying price falls, traders can make far more through put ownership than through short-selling. The dangers associated with short-selling are unbounded because the stock price has the potential to climb indefinitely.
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