What Are Options |Long Puts | Profit From a Stock Price Decrease
Introduction | Buying Puts
Although numerous investing strategies exist most investors employ a unidirectional approach when it comes to managing their investment portfolio. They simply purchase stock in a specific company and wait for price appreciation. That is, they attempt to utilize the canonical adage “buy low, sell high”. However, many investors don’t realize that they can profit when a stock price declines as well. Short selling a stock is one option that allows investors to profit from price depreciation. Shorting a stock involves borrowing shares from your broker with the intention of returning the shares at a lower price and thus and pocketing the difference as profit. Therefore, one can make money when the price of the stock falls. However, short selling a stock is an incredibly risky strategy because losses are accrued when the stock price rises, and prices can theoretically rise without limit. Therefore, the potential risk involved in shorting stock is unlimited. Conversely, the long put strategy represents an alternative to selling a stock short and allows an investor to profit from a stock price decline with a minimal amount of risk. The maximum profit for the long put strategy is only limited by the stock price falling to zero.
What Does Going Long a Put Mean?
Going long a stock option simply means that you purchase the contract. On the other hand, selling an option contract is considered going short. In this case, the long put strategy, refers to the act of buying put options on a specific underlying stock without actually owning the stock. The long put strategy allows an investor to place a leveraged bet that the price of the underlying stock will fall. Put options increase in value when the stock price declines and therefore allow the investor to profit from the decrease in price. The long put strategy is different than the protective put strategy in which an investor actually owns the underlying security and uses the put option to minimize his downside risk.
What Are Options | When To Buy a Put
In general, there are two reasons an investor would want to go long put options. First, when an investor has an extremely bearish stance on a particular stock and wants to generate increased profits via the power of leverage but without risking a large amount of his investment capital. Options are a leveraged instrument because each contract grants the right to control 100 shares of stock while costing only a fraction of the price of actually purchasing 100 shares. Going long a put allows an investor to establish a leveraged short stock position but requires less capital and thus less risk than actually selling the stock short. Secondly, an investor might want to go long put options on securities he owns in his portfolio. These protective puts act as an “insurance policy” or "hedge" against loss by allowing the buyer to sell his stock at a specified price regardless of how far the stock price falls. In order to trade options you will need approval from your broker and a margin account. Check out optionsXpress to get started.
What Exactly is A Put Option?
A put option is contract between a buyer and a seller that grants the buyer of the option the right to sell the underlying security at the strike price, before the expiration date. Typically, one put option is equivalent to 100 shares of the underlying stock. The buyer of the put option must pay a fee, called a premium for this right, but is never obligated to sell the stock and hold the contract past the expiration date, at which point it becomes worthless. Since the buyer is never obligated to sell shares of the company he can establish a long put without actually owning the underlying stock. If the stock price falls, the investor stands to gain a leveraged profit, however if the stock price rises the investor can lose the entire amount paid in premium.
Long Put Video Example
BP Oil Spill
What Are Options | Long Put Example
The long put strategy is essentially the opposite of the long call. A long put is an easy way to take a position on market direction without a large amount of risk. However, even though the amount of capital at risk is typically less when using options, an options investor stands to lose his entire initial investment if the trade doesn’t work as planned. Lets take a look at a hypothetical long put trade.
BP p.l.c. (BP) is an international oil and gas company. The company was responsible for a massive oil spill in the Gulf of Mexico in 2010 that damaged hundreds of miles of costal wetlands and beaches. Many fisherman that depend on the ocean as the source of their livelihood were negatively affected by the spill and have filled ligation against the company for reimbursement of their lost wages. While the stock price of BP has fallen drastically, you believe that thousands of costal workers have yet to file claims and that BP will be forced to pay billions of dollars in reimbursement to the victims of the oil spill. Therefore, you have an extremely bearish stance on BP and want to profit from what you believe will be a drastic drop in BP’s stock price. BP currently traders at $48.20/share and you purchase the Jan 21 2012 47.5 put option. The option cost $5.25/share but since it grant you the right to sell 100 shares, the total cost is $525. For simplicity, we'll ignore any commission fees in this example.
The break even point (BE) of this trade would be $42.25 meaning you need the stock to go below this point to gain any profit.
Long Put - Profit Loss Graph
Long Put Trade Outcomes
At the close of the market on Jan 21st 2012 the trade has 3 different outcomes.
- At market close BP could be trading at $55/share. In this scenario, you were wrong about the price decline and lose the entire premium paid to establish the long put strategy. The stock price is higher than the strike price of the option and thus is considered to be "out of the money". You lose 100% of your initial investment but have limited to our loss. Had you actually shorted 100 shares of BP at $48.20 you would have a loss of $680. If the stock price continues to rise this loss would also increase. However, regardless of how the stock price climbs, using the long put strategy, your loss is limited to $525.
- At market close BP could be trading for $45 per share. The long put will have an intrinsic value of $250. You could sell the option in the open market before expiration or purchase 100 shares of BP at $45/share and then exercise put option and sell the shares at $47.50. However, since the cost of the put option was $525 you still acquire a loss on the trade of $275. After trading and exercise fee, your loss will actually be more.
- At market close BP might be trading for $30/share. In this case your thesis was correct and since the stock price is less than the strike price of 47.50 your option is considered "in the money" and will have an intrinsic value of 17.50 and be worth $1,750. You can either sell the contract prior to the expiration date, or purchase BP at 30 and sell it for $47.50/share. Before commission you will have a profit of $1,225. Here is where leverage comes into play. Had you actually shorted 100 shares of the stock at $48.20 your profit would be $1,820, however the cost of the purchase was $4,820, thus giving you a return of 37%. Not to shabby, but your risk was unlimited had the stock price climbed. Alternatively, using the long put you risked a maximum of $525 and your total return is 233%. In this case the long put strategy allowed you to minimize your risk and maximize your profit.
Of course the amount you pay in commission will after the actual profit and rate of return, and these need to be accounted for in a real options trade.
In conclusion, using the long put options strategy can allow an investor to profit when the price of a stock decreases. However, the long put buyer needs to successful predicting the price a stock will fall to and the time point by which it will happen. This is not a trivial task and therefore only capital in which an investor can afford to lose should be used for purchasing stock options since one can lose their entire investment. When used appropriately the long put can provide another tool for investors to help achieve their investment goals.
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