Introduction To Long Put Options Strategy
A long put options strategy involves buying put options with the projection that the price of the underlying security will trade below the exercise(strike) price of the put option before expiration. In general, as the price of the underlying security decreases, the option price of the put increases. When the price of the put increases, the trader can sell to close his trade at a profit.
While buying a put option, the trader must consider the time to expiry of the option. The trader believes that the price of the underlying security will move significantly below the exercise price of the put before expiry, such that the trader can earn a profit when the put option is deep in the money. For a buyer of an option, time value is always depleting.
Another consideration that the trader should make when buying a put is implied volatility levels. Traders should buy put options that have low implied volatility, so as to avoid paying an expensive premium for the put option.
Margin requirement for a long put
No margin is required to purchase a long put as this strategy’s maximum risk is the loss of the premium paid for the put option.This also necessarily means that the risk is not unlimited.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Bearish
Step 3 : Study the option chain and review option premiums
Step 4 : Breakeven Analysis
Step 5 : Understand Your Profit Zones
Step 6 : Limited loss
Step 7 : Calculate Loss
Step 8 : Unlimited potential profit
Step 9 : Calculate Profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a long put
Step 12 : Exiting a long put position
Step 13 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Before purchasing a put option, an options trader must perform economic analysis, fundamental analysis and technical analysis. Put options generally increase in premium when the price of the underlying security goes down. In a weakening economy, poor fundamentals in an underlying security and a technical outlook to the downside, a long put strategy has a high probability of being profitable. The trader should also review price and volume charts over the last 12 months to investigate price trends and liquidity. Some suggested chart patterns option traders should look out for is:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
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Step 2 :Outlook – Bearish
The trader that longs a put is very bearish on the underlying security. He predicts that the price of the underlying security will fall, which will in turn cause the option premium for the put to increase.
Step 3 :Study the option chain and review option premiums
If an options trader has reason to believe that the price of an underlying security will head downwards, then he should start to examine the options chain to select put options for a long put strategy. The options trader can choose to use ITM, OTM or ATM put options. Also, the options trader should look for options with low implied volatility. When implied volatility is low, option premium is also low. The options trader is advised to select options with 60 to 90 days to expiration. This gives the put option enough time to capture a price move to the downside.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
There is one breakeven point in a long put strategy. The breakeven point can be calculated as:
Exercise or Strike Price of Long Put – Net Debit Paid For Put
The debit paid for the put is the put premium.
Step 5: Understand Your Profit Zones
After the breakeven point is calculated, one will understand the profit zone of a long put strategy. As long as the price of the underlying security is below the breakeven point, the trade is in profitable territory.
Step 6 : Limited loss
The loss is limited to the option premium paid for the put option and this occurs when the price of the underlying security is greater or equal to the exercise price of the put option at expiration.
Step 7 : Calculate Loss
The loss can be calculated as :
option premium paid for put + commissions paid to broker
Step 8 : Unlimited potential profit
The price of the underlying security can theoretically go to 0. This is the best case scenario for a trader. The maximum profit per share in this case is thus the exercise price less the price paid for the put option.
Step 9 : Calculate Profit
The profit per share is calculated as :
(Exercise price – price of underlying security) – price paid for put option
Calculating percentage profit or loss/ Return on investment percentage
When calculating percentage profit or loss, one should take note of the buying price of the put option and the selling price of the put option. When the buying price of the put option is less than the selling price of the put option, a profit results. That percentage profit can be calculated as:
(Selling price of put option – Buying price of put option)/ Buying price of put option x 100%
Similarly, when the selling price of the put option is less than the buying price of the put option, a loss results. The percentage loss can be calculated as:
(Buying price of put option – Selling price of put option)/ Buying price of put option x 100%
Step 10 : Calculate Risk & Reward Ratio
The maximum risk is the premium paid for the put, that is, the net debit. Since the reward can be estimated by estimating the target price at which an options trader would like to exit the put, the risk and reward ratio can be estimated. Be certain that the the risk and reward ratio is attractive.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade : Executing a long put
To long a put, an options trader can buy ATM, ITM or OTM puts.In the example below and for the purpose of this tutorial, we are using a scenario of ATM puts.
Step 12 : Exiting a long put position
There are several ways to exit a long put position.
- The easiest way is to let it expire worthless. The trader will lose the entire option premium paid for the put.
- The trader can sell to close the position. This is termed as “offsetting”. The trader sells a put option with the same expiry and the same exercise price. If the price of the underlying security has fallen, the long put strategy may yield a profit. If the price of the underlying security has risen, the trader may sell at a loss.
- The options trader can exercise the put option and short 100 shares of the underlying security for every put option contract held. If the underlying security moves lower, the options trader can cover the short and earn a profit.
Time value considerations when exiting
Options are wasting assets. A put option will experience the highest rate of time decay in the last 30 days of its life. Hence, it is advisable that a long put should be exited at least 30 days before its expiration date. If a trader holds on to a put option during the last 30 days of its life,in the absence of price movements in the underlying security, the option will lose much of its value due to time decay.
Step 13 : Record Trade In Diary
After the long put is exited, the trader should record the trade in the diary and detail the performance of the trade. The trader will also do some reflection to fine tune his trading process.
Example Of A Long Put
The price of TTT Corp is trading at $40. A trader buys January 40 put because he is extremely bearish on the company. The price of the put cost $2. Hence, $200 was paid for the premium.
If the price of TTT trades at $35, the trader can close the trade at a profit of $3.
This is how we can calculated the profit.
Profit gained on the put = $40 – $35 – $2 = $3
As the put option moves from at the money to in the money, its intrinsic value increases.
If the price of TTT trades at $40, the loss on the trade is $2 because the option expires worthless.
If the price of TTT trades at $45, the loss on the trade is also $2 as the put option expires worthless.
If the price of TTT trades at $38, the trader will break even, which means that there is neither profit or loss at that price.
This is how we calculate it. The intrinsic value of the put is $40 – $38 = $2. If the trade is closed out, there is no loss or profit. That is because, $2 was paid for the put option in the first place.
$2 – $2 = $0
Hence, the breakeven price point is $38 and this is the price of the underlying security where there is neither profit or loss.
Effect Of Dividend On Long Put
When dividends are paid, there will be a positive impact on the put option premium. Put option premium will increase when dividends are paid. This occurs as the price of the underlying security adjusts downwards.
Buying in the money options vs buying out of the money options
While buying out of the money options are cheaper,it has a higher probability of expiring worthless. All things being equal, in the money options are more expensive than out of the money options due to the greater intrinsic value. While out of the money options are more expensive than in the money options, the amount paid for time value is less.
Read:
Execute A Synthetic Long Put : Bearish Strategy