Long Put Option

Like the long call, the long put option is a high risk and potentially high reward trade, comparable in my opinion to playing a slot machine.

A long put simply consists of buying a single put option either in the money, at the money, or out of the money. The trade requires the underlying stock to drop in value in order to be profitable. And it must drop enough to also cover the initial purchase price of the put.

Like the long call, the long put is a wasting asset. The put's value is comprised of its intrinsic value (how far above the current share price the strike price is) as well as its extrinsic, or time, value. All else being equal, the option will lose value every day. And the closer expiration gets, the more quickly the value erodes.

But if the stock does fall, and fall enough, the put buyer can experience some very lucrative gains.

Put Options Review

The definition of a long put is a contract which gives you the right to sell 100 shares of a stock at a certain price by a certain date.

Think of it as an (expensive) insurance policy that says, no matter what may happen between now and expiration, you will be able to sell your 100 shares of stock at such and such a price, even if the stock is trading for just pennies a share.

Do you actually have to own any shares to buy a long put? No. In fact, most put buyers aren't shopping for insurance on stocks they own - they're simply making speculative bets that a stock is going to trade a lot lower in the near term.

Because all else being equal, the put contract will increase in value, as the value of the underlying shares decline.

In practicality, buying put options are bets against the house in the hopes of hitting a jackpot. It's an aggressive play in the same way that a long call is.

The stock must drop, and drop by more than a little, for the trade to be profitable. If the stock goes up, stays flat, or even declines by a small amount, you're going to lose on the trade.

But if the stock really craters, you can make some astronomical percentage returns based on your original purchase price of the put.

Long Put Example

Suppose the XYZ Zipper Company has been trading lower and is now down to the $37/share level. You believe the company's fundamentals and, more importantly, its technicals are both bad and deteriorating. You expect the stock to continue falling in the coming weeks.

You decide to purchase a $35 put expiring ene month out for $1/contract, or for a $100 debit. The cash balance of your brokerage account is reduced by $100.

The $35 put on a $37 stock is considered out of the money, and so it consists entirely of time value, or extrinsic value.

If the stock closes at $35 or higher, the option will expire worthless. In fact, you would need to the stock to close around $34/share just to break even (roughtly - that's excluding commissions and any bid-ask spread penalty).

But let's suppose you were right about the stock. Perhaps some negative news is released and the stock continues falling so that at expiration, the stock closes down at the $33/share level.

Your $1 long put is now worth $2/ contract (the difference between $35/strike price and the $33/share price).

Most likely you would've simply sold to close the put for (roughly) the $1/contract (i.e. $100) profit, which also represents a 100% gain on the original $100 purchase price of the long put.

If for some reason, you held the long put through expiration and you didn't own the underlying shares, the put would still be exercised automatically.

The result would be that on Monday morning, you would find that you had $3500 of cash in your brokerage account along with a short stock position on XYZ. You could either keep that short stock position if you believed the shares would continue falling, or you could close that trade by buying those 100 shares back at the $33/share current price for the same $100 profit (short sale proceeds of $3500 less the $3300 cost of covering the shorted stock less the initial $100 purchase price of long put).

If you would've shorted the 100 shares of stock in lieu of buying the put, you would've made $400, or a 10.8% return based on the $37/share price and assuming you covered your short at $33/share.

But you also theoretically would've exposed yourself to unlimited upside risk. Suppose instead that the stock had traded higher, not lower. Or what if another company made an offer to acquire XYZ for a 30% premium to its current share price?

With the long put, however, the most you could've lost was the initial $100 purchase price. And your ultimate return of $100 represents a 100% return on your invested capital.

Long Put Variations

Although you may not risk a huge dollar amount by buying a long put, the trade is still an inherrently risky strategy since the underlyng stock MUST make a strong move downward, and in a certain time period, for you to make money.

It's also risky in the same way as the long call is risky - it's very difficult just to break even. In my opinion, you're very likely to get some kind of double digit return - it's just that you never know if it's going to be positive or negative.

But a long put, like a long call, and, for that matter, like just about all option strategies, it can be made to be more risky or less risky. As I say repeatedly about options - they're a risk dial, not a risk switch, and you adjust the risk to an extent on a long put by adjusting these factors:

The Strike Price - The deeper in the money you go with your long put, the more likely the put will be in the money at expiration and therefore retain some intrinsic value. (DITM) the strike price is, the more the put is comprised of intrinsic value rather than time value. And it's time value that kills the buyer of options. Intrinsic value means there's something of real value there, something that will remain on Expiration Friday even if the stock doesn't get to where you wanted it to go. Obviously then, an ITM put will require more capital upfront than its OTM counterpart, and on a percentage basis, the potential returns will be much less. But with an ITM option (and especially a DITM option), your risk of losing your entire investment is diminished.
The Expiration Date - In the same way, the farther out in time the Expiration Date is, the more time you allow the stock to move lower. The downside, of course, that the farther out in time the Expiration Date is, the more you'll have to pay for the option. That again equates to a larger capital investment and therefore a reduction, on a percentage basis, of your potential returns.

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