Long Put

The Long Put Setup

Suppose you think that a company named Decline Corp., which now trades for $200 per share, would face great difficulty in the next quarter and, as such, would decline in stock price. To account for her anticipated decline, you decide to buy a put with a strike price of $190 expiring in three months and you pay a premium of $10 per option.

Who Should Consider It

Long put traders are most compatible with bearish investors who foresee a marked drop in the underlying asset’s market price. It is also for traders who would like to hedge their portfolios or assets while incurring a lesser amount of risk due to the controlled nature of the strategy.

Strategy Explained

By buying a put option, you buy the right, but not the obligation, to sell the underlying asset at a set price (the strike price) before the option expires out of money. This will allow one to benefit from price drops without going short on a stock, which involves unlimited risks.

Breakeven Process

The breakeven point for a long put position is determined by the strike price less the premium paid on the option. Using Decline Corp as an example, we have $190 (strike price) - $10 (premium paid) equaling $180. The underlying must decline to above $180 before expiration for the buyer of a put option to begin realizing gains.

Sweet Spot

The sweet spot for this strategy would occur when the price of the underlying has plunged well below the breakeven point. The deeper the fall below $180, the larger the profit potential.

Potential Maximum Profit

The maximum potential profit of a long put can be substantial but is limited. The maximum profit therefore will be realized only if the underlying asset collapses from present value to zero. Thus, should DeclineCorp go bankrupt, bringing its stock price to $0, its long put option would profit by the strike price less premium paid. In this case, the profit is therefore equal to $190 - $10=$180 a call option.

Maximum Loss

The maximum loss is limited to the intrinsic premium paid for the put option. Assuming that DeclineCorp keeps trading while its shares are still above the $190 strike price, the put itself will lose its value, and the $10 per share premium you paid will be your loss.

Risk

Risks of long put are simply risks associated with buying puts, most of which revolve around a potential devaluation of the premium paid, as the long put the bottom line lever does not react as quickly as expected. A loss on put premium is confined to the paid premium, making it a defined risk scenario.

Theta or Time decay

Time decay or theta is an inherent risk in long put strategy since it wears away with the option approach expiration. This becomes pronounced as the option nears its expiration date, especially if the underlying asset’s stock price remains above the strike price.

Implied Volatility

High implied volatility usually offers choices at a higher price, while a minor probability of a downturn amplifies the likelihood of possible profit. In case implied volatility drops after the purchase of an option, the value of the option might diminish in spite of a sharp decline in stock price.

Conclusion

Long put strategies can give investors the chance to profit from declining movements in the stock market or hedge certain existing stock positions while maintaining a perfectly defined risk profile. The key shortcoming of the long put strategy is timing and the subsequent effect of time decay and changes in volatility. It is most valuable during periods of uncertain market conditions or bear market predictions.