Long Puts Strategy Copy

Buying Puts – Playing a Bear Market 

The speculative purchase of put options is the simplest way for traders to use option contracts to benefit from a decline in value of the underlying stock. Put options are one of the building blocks of many more sophisticated options strategies.

In this level will address the particular use of the long put as a speculative, bearish strategy.

Although put options may be exercised by its owner at any time up until the last trading day for the contract, and underlying shares sold, speculative put buyers generally expect to sell them for a realized profit at some point before they expire.

The speculative long put option is a directional strategy. Profits are realized when the investor is successful in picking stocks that decrease in value. 

In this course, we only refer to the speculative use of the long put option, but you should know that many investors choose to use put contracts to protect the value of an equivalent number of underlying shares they own. The put option owner has a guaranteed selling price which is the strike price, and that is why they are commonly used to hedge an underlying stock position.

Strategy Overview

Strategy: Long 1 Put of a Stock

Market Opinion: Bearish

Trades buy put contracts as a speculative strategy when they are bearish on the price of the underlying stock. For the lifetime of the put contract, a put buyer has the opportunity to profit from the decreasing value of the stock with a predetermined fixed risk. The strategy we will use is focused on selling the put contracts and realize a profit before they expire.

Benefits

Buying puts generally require a smaller initial cash investment than the margin requirements to short sale the underlying shares and profits could represent larger percentage gains. No other equity option strategy offers investors more leveraged downside potential in a declining market.

On the other hand, there are disadvantages to utilizing equity put options. For instance, the same leverage that can result in large percentage profits on the downside can also result in large, though limited, percentage losses on the upside. 

Profit Potential

Maximum Profit Potential: limited only by the underlying stock declining to zero

Loss Potential

Loss potential for the long put strategy is limited to the premium paid for the contract. 

Break-Even Point

Strike Price – Premium Paid

Effect of Volatility

If Volatility Increases: Positive Effect

If Volatility Decreases: Negative Effect

Whether volatility levels increase or decrease, it is the time value portion of the option premium that will be affected.

Effect of Time Decay

With the passage of time, the time value portion of a put’s premium generally decreases, this is a negative effect for an investor with any long option position.

Passage of Time: Negative Effect

Long Puts Vs Short Stocks

Potential Profit

Short-Stock
Profit for a short sale of a stock is theoretically limited only by the stock’s potential decrease to no less than zero. Once a short sale is transacted, profits can accumulate as the market price of the stock declines.

Long Put
Profit for a long put is likewise theoretically limited only by the stock’s potential decrease to no less than zero. Once a put is purchased, profits can accumulate as the market price of the stock declines.

Potential Loss

Short-Stock
Loss potential for a short stock position is theoretically unlimited. Once a short sale of stock is transacted, losses can accumulate as the market price of the stock continues to increase.

Long Put
Maximum loss potential for a long put (or call) position is limited to absolutely no more than the premium paid for the contract, no matter how high the price of the underlying stock rises.

Borrowing Stock

Short-Stock
A short sale of stock in the marketplace requires that those shares be borrowed for delivery to their purchaser. This process is fairly routine with most brokerage firms, but it is not within the scope of this class to describe it in more detail. Because the sold shares must be borrowed from an investor willing to lend them, this is not always possible. At times certain issues of stock may be difficult or impossible to borrow, so short sales of stock are not always achievable.

Long Put
Purchasing an equity put option does not involve borrowing shares of underlying stock.

Initial Margin Requirements

Short-Stock
Initial margin requirement for a short sale of stock can be quite large, and can vary with each brokerage firm. At times, the margin required can be as much as 150% of the total value of the shares sold short.

Long Put
There is no “margin requirement” for purchasing put (or call) options. The puts must be paid for in full – a dollar amount that is most often considerably less than the initial margin requirement for a short sale of an equivalent number of shares.

Margin Calls

Short-Stock
When the market price of shares previously sold short increases, additional funds may be required and requested by a brokerage firm to maintain a current margin requirement. This is known as a “margin call.”

Long Put
No margin calls can be received for a long put (or call) position. Once a put (or call) is purchased, no additional funds are required to maintain this position.

Dividends

Short-Stock
While an investor is short shares of any stock issue, that investor must pay out to the stock lender any corporate dividends (i.e., regular and/or special dividends or distributions of any sort) that the lender is entitled to receive.

Long Put
Owners of long puts do not pay dividends while they are long the contracts.

Upside Comfort Level

Short-Stock
Investors with short stock positions have theoretically unlimited risk on the upside. As the shares sold short increase in value, losses can mount. Concern over this unlimited risk can result in investors “covering” (with a closing stock purchase transaction) the shares to cut this risk and realize a loss.

Long Put
Although long puts can lose all or part of their value as the underlying stock continues to increase in price, this loss is predetermined. It is limited to the premium paid for the contracts.