A long put can be an ideal tool for an investor who wishes to participate profitably
from a downward price move in the underlying stock. Before moving into more complex
bearish strategies, an investor should thoroughly understand the fundamentals about
buying and holding put options.
Bearish
Purchasing puts without owning shares of the underlying stock is a purely directional
strategy used for bearish speculation. The primary motivation of this investor is
to realize financial reward from a decrease in price of the underlying security.
This investor is generally more interested in the dollar amount of his initial investment
and the leveraged financial reward that long puts can offer than in the number of
contracts purchased.
Experience and precision are key in selecting the right option (expiration and/or
strike price) for the most profitable result. In general, the more out-of-the-money
the put purchased is the more bearish the strategy, as bigger decreases in the underlying
stock price are required for the option to reach the break-even point.
A long put offers a leveraged alternative to a bearish, or "short sale" of the underlying
stock, and offers less potential risk to the investor. As with a long call, an investor
who purchased and is holding a long put has predetermined, limited financial risk
versus the unlimited upside risk from a short stock sale. Purchasing a put generally
requires lower up-front capital commitment than the margin required to establish
a short stock position. Regardless of market conditions, a long put will never require
a margin call. As the contract becomes more profitable, increasing leverage can
result in large percentage profits.
Maximum Profit: Limited Only by Stock Declining to Zero
Maximum Loss: Limited
Premium Paid
Upside Profit at Expiration: Strike Price - Stock Price at Expiration - Premium
Paid
Assuming Stock Price Below BEP
The maximum profit amount can be limited by the stock's potential decrease to no
less than zero. At expiration an in-the-money put will generally be worth its intrinsic
value. Though the potential loss is predetermined and limited in dollar amount,
it can be as much as 100% of the premium initially paid for the put. Whatever your
motivation for purchasing the put, weigh the potential reward against the potential
loss of the entire premium paid.
BEP: Strike Price - Premium Paid
Before expiration, however, if the contract's market price has sufficient time value
remaining, the BEP can occur at a higher stock price.
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option's total premium is on the time value portion.
Passage of Time: Negative Effect
The time value portion of an option's premium, which the option holder has "purchased"
when paying for the option, generally decreases, or decays, with the passage of
time. This decrease accelerates as the option contract approaches expiration. A
market observer will notice that time decay for puts occurs at a slightly slower
rate than with calls.
At any given time before expiration, a put option holder can sell the put in the
listed options marketplace to close out the position. This can be done to either
realize a profitable gain in the option's premium, or to cut a loss.
At expiration most investors holding an in-the-money put will elect to sell the
option in the marketplace if it has value, before the end of trading on the option's
last trading day. An alternative is to purchase an equivalent number of shares in
the marketplace, exercise the long put and then sell them to a put writer at the
option's strike price. The third choice, one resulting in considerable risk, is
to exercise the put, sell the underlying shares and establish a short stock position
in an appropriate type of brokerage account.