Long Put Option Strategy

Put options can be thought of as insurance for stocks. Much like how an insurance policy will pay out for the value of a car if its significantly damaged, a put option will ensure you can sell stocks at an agreed upon price if the stock price falls in the future. And much like an auto insurance policy, the buyer of a put option pays a premium for the certainty of receiving the agreed payout. Investors often purchase puts to protect their portfolio’s value against falling prices. Purchasing a put option while holding long the underlying security is called a protective put option strategy, a type of hedge. The unrealized loss from the stock position is offset by the protective put which will increase in value. The protective put option gives the investor flexibility to sell the stock later even if the price falls.

Investors can also buy put options without holding on to the underlying securities. This is known as a long put option strategy, and is used to speculate on future bearish movements, rather than to hedge risk. Investors who foresee the price of a stock going down can position themselves to profit by purchasing puts. If the speculator is correct and the stock price drops, the put will gain value and can be sold for a profit, or the investor can buy the declining shares and exercise the put to sell them at a gain. This strategy allows investors for greater flexibility and leverage in a bear market. However, if the stock price increases or trades sideways, the option will expire worthless, and the speculator will lose the premium.

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Features of a Put Option:

‌ The basic features of a put option are as follows:

• Premium: The purchase price of an option. Paid by buyers, received by sellers.
• Multiplier: Each standard option contract covers a hundred shares. An option with a premium of $1 is worth $100, as it covers 100 shares.
• Strike price: The pre-determined price at which the investor may sell shares if he chooses to exercise the contract.
• Expiration date: The last day the option contract exists. If an option is to be exercised, sold back for profit, or sold to recoup loss, it must be done on or before this date.

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An Example of a Protective Put

Suppose you hold 100 shares of EIO, a publicly traded company that sells livestock to farmers.* You bought 100 shares of EIO at $6 this year and currently it’s trading at $10. At this point, the position you opened for $600 is worth $1000, and you have an unrealized gain of $400.

In the short term you anticipate that with the recent growing trend in vegetarianism that revenues of EIO will fall short of expectations as farmers buy less livestock. You’re concerned that the stock price could react badly and might fall below your original purchase price. To protect your investment, you purchase 1 put option with a strike price of $10 for a $2 premium which expires in December. This contract costs a total of $200, the $2 premium multiplied by the 100 shares covered by the contract.

Shortly after you purchase the put, a report comes out stating consumers are eating more salads than before, and this causes EIO stock to sell off to $6. For the remainder of the year the price of EIO continues to trade lower and finally approaches $2 per share in December. At this point you decide to exercise the put option to sell your shares at $10. You collect $1000 in exchange for your 100 shares of EIO, which is $400 dollars more than you paid for them, and $800 more than you could sell them for on the open market.

By purchasing the protective putfor $200, you locked in a gain of $200. You can calculate this by taking the strike price of the put you exercised ($10), subtracting the per-share cost of your stock position ($6), and subtracting the premium you paid for the option ($2), then multiplying the result by the standard option multiplier of 100 shares. ($10 – $6 – $2)*100 = $200

The stock position alone, without the protective put, would have resulted in a loss of $400 over the same period, as your $600 position dropped all the way to $200.

However, if the stock had continued to trade higher than $10 up until December the $200 put you purchased would have lost it’s entire value.

Let’s look at the same scenario from the standpoint of a speculator, rather than a hedger. When hedging, you used the put to offset risk to a long position, but as a speculator, you purchases the put alone. Expecting the market may turn bearish, you buy a long put in EIO for a premium of $2 at the $10 strike price and December expiration. Just like the previous example, this costs you $200. The price of EIO falls to $3 and you sell the put, which is now worth $8, netting a $600 profit.

Of course, just like the previous example, if the stock price had traded higher, you’d have lost the full amount of your premium. But unlike the previous example, you wouldn’t have the long stock position in your account. This means that you wouldn’t benefit from these gains, but you also wouldn’t have any losses that needed to be offset. The right strategy for you will depend on your personal market attitudes, and appetite for different kinds of risk.

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Let’s Analyze the Profit and Loss Profile of a Long Put:

You buy one EIO put option at the $10 strike price with 12 months until the expiration date for a premium of $2.

Since one option contract covers 100 shares, this option contract that has a $2 premium, costs $200 in total. The maximum potential profit is the strike price of $10 less the $2 premium multiplied by 100 shares. This is calculated as follows:

Maximum Profit per Option = (Put Option Strike Price - Premium) x 100 shares

$800 = ($10- $2) x 100 shares

‌So, if the price of EIO were to decline to $0, the max profit is $800.

The maximum potential loss is the premium of $2 paid for the put option multiplied by the 100 share multiplier. This is calculated as follows:

Maximum Loss per Option = Premium Paid x 100 shares

$200 = $2 x 100 shares

‌So if the price of EIO trades above $10 and settles out of the money by the time the put option expires, you will lose a maximum of $200.

The breakeven point is the $10 strike price of the option less the $2 premium. This is calculated as follows:

Break Even Point = Strike Price - Premium Paid

$8 = $10 - $2

In order to break even on the trade, the price of EIO needs to decline past $8 per share by the expiration date.

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The potential profit and loss of the long put option strategy by the expiration date can be seen in the chart below.

The chart shows the potential profit and loss on the y-axis versus the corresponding stock price in the x-axis.

If the stock price of EIO remains above $8, you will take a loss anywhere between $0 and $200, as indicated in the red shaded region. If the stock price of EIO falls below $8, the put option strategy becomes profitable as indicated in the green shaded region. As the price of EIO approaches $0 the profit increases up to a potential maximum gain of $800. The breakeven point is $8, which is the strike price of $10 less the premium paid of $2.

If EIO falls below anywhere between $10 and $0 during the duration of the option contract, you may choose to exercise the option. This means you’re exercising your right to sell 100 shares of EIO at $10.

If you hold shares of EIO long, the shares would be sold at $10, regardless of what price EIO stock is trading at.

If you’re only long the option and not the underlying shares, you can still choose to exercise the option, but this will create a short position in EIO. In order to hold a short position, you must have a margin account, at least $2,000 in equity, and sufficient equity to hold the short position in EIO. If those conditions are not met, you cannot exercise a put without holding the shares.

Thirdly, if you aim to profit from the decrease in EIO’s share price without having to exercise the option, you can sell the option on the open market anytime before the option expires. If EIO remains above $10 by the expiration date the option will expire worthless and you will incur a permanent loss of the $200 invested.

From these examples, you can see how put options offers leverage, flexibility, and protection, whether you’re speculating on a price decline or holding the underlying shares. The long put provides leverage, allowing you to control a $1000 position for only $200, and to profit more (in percentage terms) than simply buying and selling the underlying shares.

Put options offer flexibility, allowing you to decide if you want to exercise the option to sell shares, or simply sell the put at a higher or lower price. And put options offer protection against a decline in the price of the stocks you’re holding.

There are many of ways to use put options, and some may be just right for your strategy. Remember to always research thoroughly and consider all the risks before investing.

*The tickers are fictitious and are only intended to illustrate examples of complex option strategies.

All prices used in the examples are not representative of actual prices options can be worth at any time.