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Lesson 4:

Understanding Purchased

(Long) Puts

Long puts follow the same mechanics as long calls, the main difference being puts contain the right to sell. Purchased contracts are intended to contain as much value as possible.

Lesson 4: Understanding Purchased (Long) Puts

Understanding Purchased (Long) Puts

long put

Long puts are purchased to open

Let’s break down a long put. Long means purchased and put means contains the right to sell. To create a long put, the trader buys to open the put and pays a premium in the form of a debit.

Maximum loss is limited to the premium paid

Only option buyers can execute upon the terms of the contract. This means that long puts are exercisable. In this example, the long put holder owns the right to sell ABC at $100 at any time through the expiration date. In simpler terms, it’s the buyer’s decision, they decide when they would like to sell the shares if at all. The long put holder pays a premium (options price) for the contract. As the long put holder decides when to exercise, the most that can be lost is the premium paid for the option. In this example, the maximum loss is limited to $5 per share or $500 total.

Lesson 4: Understanding Purchased (Long) Puts

Understanding Purchased (Long) Puts

long put

Long puts have substantial profit potential

When purchasing an options contract, the contract holder wants the option to go up in value as much as possible. The long put holder owns the right to sell at the $100 per share strike price. Therefore, the put holder wants the ABC stock to decline well below the $100 strike price as this creates contract value. As ABC can potentially decrease to zero, this means a long put contains substantial profit potential.

However, the long put holder paid $5 per share or $500 total for the right to sell 100 shares of ABC at $100 per share at any time for the next 60 days. On expiration, an option is generally only worth its executable value – this is also called in-the-money (ITM) value or intrinsic value. If ABC is at $95 per share on expiration, the long put holder would break-even and not realize a gain or a loss. This is because the long put holder can purchase the shares at the $95 market price and immediately execute upon the terms of the contract to sell ABC at $100 per share. This would create a gain of $5 per share, offset by the $5 per share purchase price of the put, resulting in break-even.

Time is working against long options

Options that contain longer expiration dates will be more expensive as there is more time for the option to rise in value. As the option nears expiration, the time value component of the options premium will deplete. When purchasing options, it may be beneficial to sell to close the long options prior to expiration to recoup or recapture any time value purchased. Essentially, there are other pricing factors that affect an options premium outside of the underlying security. This is why options do not move in tandem with the underlying position.

Lesson 4: Understanding Purchased (Long) Puts

Long Put

Profit/Loss at Expiration

profit and loss

This option is in-the-money (ITM) or has executable/intrinsic value when the underlying position (ABC) is trading below the $100 strike price. This is because the put contains the right to sell 100 shares of ABC at $100. Therefore, if ABC is trading at $99.99 or lower the option has executable value as selling at the strike offers a better price than selling at the market price. Any options premium more than the intrinsic value is considered extrinsic value which will deplete as the option nears expiration. If ABC trades above the $100 put strike at expiration, the put option will have no intrinsic or extrinsic value and will simply expire worthless. Therefore, a long put option profits from a sharp downward movement in the underlying and as the option nears expiration, time value depletes from the premium.

Lesson 4: Understanding Purchased (Long) Puts

Key Takeaways

checklist

1. A long put option is a purchased option that contains the right to sell 100 shares of an underlying asset at the strike price executable at any time through the expiration date. The contract is purchased for a premium, the long option holder wants the option to contain as much value as possible.

2. To create a long a put option, the investor will buy to open the put. The value of the put option will change during the lifetime of the contract and, at any time, can be sold to close, or can be held until expiry to be exercised or expire worthless. This generates either a profit or a loss on the trade.

3. A long put is bearish and profits from a sharp downwards movement in the underlying. As the underlying position can decrease to zero, the strategy has substantial profit potential.

4. All else equal, time works against this strategy. This is because the extrinsic value of an option will depreciate to $0 by expiration and in doing so, will reduce the overall premium of an option.

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Lesson 4:

Knowledge Check

Lesson 4: Understanding Purchased (Long) Puts

Knowledge Check

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What is the maximum amount a trader can lose when purchasing a long put option?

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Lesson 4: Understanding Purchased (Long) Puts

Knowledge Check

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If a long put option with a strike price of $100 is purchased for a $5 premium, at what stock price at expiration does the option holder break even?

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Lesson 4: Understanding Purchased (Long) Puts

Knowledge Check

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Why does a long put option have substantial profit potential?

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Understanding Purchased (Long) Puts

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