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Lesson 2:

Strategy | Long Puts

Lesson 2: Strategy | Long Puts

Strategy | Long Puts

Purchased the right to sell an optionable ETF or equity.

A long put option is a bearish options strategy that allows an investor to profit from the anticipated decline in the price of a specific underlying asset, such as a stock, an exchange traded fund (ETF) or index. This strategy is established by purchasing a put option contract for a premium, granting the holder the right to sell the underlying asset at a predetermined price, known as the strike price. This right can be exercised at any time before or on the expiration date of the option.

Lesson 2: Strategy | Long Puts

Strategy

Highlights

checklist

Your Sentiment:

Bearish

Ideal Expectations:

Sharp directional move below strike price greater than the premium paid, increase in implied volatility.

What works in your favor:

The underlying decreasing in value, an increase in implied volatility.

What works against you:

The stock rallying, time value depletion, a decrease in implied volatility.

Long Equity Put P/L Chart at Expiration

profit loss

Risk:

Limited to premium paid, occurs when the underlying remains at or above the strike price.

Breakeven:

Occurs when the underlying declines below the strike price only by the premium paid. The stock price equals the strike price minus the premium paid.

Reward:

Substantial potential as the stock price declines below the breakeven point and can theoretically fall to zero.

Lesson 2: Strategy | Long Puts

The primary objective of employing a long put strategy is to capitalize on the anticipated decline in the value of the underlying asset. Investors who utilize this strategy believe that the asset's price will fall sharply below the strike price, more than the premium paid.

Trade Anatomy & Example:

abc

Disclosure: Example for educational purposes only and does not include commissions and fees.

Imagine that you, as an investor, have a bearish sentiment toward ABC stock. You anticipate that ABC's current price of $100 will decrease significantly, possibly reaching $90. With this sentiment, you decide to employ a long equity put strategy. Upon order entry, the trade is entered as ‘buy to open’ indicating that the long put is purchased to create, or in other words, open the position. Therefore, you buy to open 1 ABC $100 strike put for a premium of $3 ($300 total). This means you own the right to sell 100 shares of ABC at $100 per share at any time through the expiration period and purchased this right for $3 per share.

Remember, an option premium is comprised of intrinsic value and extrinsic value. Which means that option’s price is affected by more than just the underlying security, time and implied volatility also impact the option premium. Understanding the external impacts helps establish a sentiment and entry and exit strategies.

Lesson 2: Strategy | Long Puts

abc

Disclosure: Example for educational purposes only and does not include commissions and fees.

Impact of Time Value Depletion:

One critical aspect of long put option is time decay. The time value of the premium paid for the option (in this case, $3) diminishes as the option approaches its expiration date. This means that the longer it takes for the stock price to move in your favor, the more time value depletion will negatively impact your position.

Benefiting from Implied Volatility:

As a long put holder, you stand to benefit from an increase in implied volatility. When implied volatility rises, options premiums tend to expand. This means the long put holder may expect an increase in implied volatility.

Lesson 2: Strategy | Long Puts

Gain & Loss Scenarios:

To add clarity, let’s look at various scenarios when a long put is at a gain, loss and breakeven at expiration. Upon order entry, closing transactions are entered as ‘sell to close’ indicating that you intend to exit the position or in other words close the position.

scenario one

Suppose ABC stock reaches your target price of $90 on the expiration date of the put option. In this scenario you hold an in-the-money option at expiration. An in-the-money option contains intrinsic or in other words, executable value.

  • You have the right to sell ABC shares at the $100 strike price.
  • Your gain is the difference between the market price ($90) and the strike price ($100), which is $10 per share.
  • The total gain from one contract is $10 x 100 shares = $1,000.
  • Subtract the premium paid ($3 x 100 shares = $300), and your net profit is $700.

At expiration, your contract is generally only worth its executable value. In this example, you hold an in-the-money option with $10 of executable/intrinsic value as you could execute upon the terms of the contract and sell ABC at $100 per share after purchasing at the market price of $90 per share. This means that you should be able to sell to close your contracts for at least $10 per share. It is important to note that an options price fluctuates through the day of expiration. By holding the option to the expiration date, you will have forgone any time value purchased.

Lesson 2: Strategy | Long Puts

scenario two

If ABC stock fails to decline beyond the $100 strike price by expiration, your long put option expires worthless, and you incur a loss equal to the premium paid. In this case, the loss is $3 x 100 shares = $300.

You hold an out-of-the-money option on the day of expiration. It will be difficult to sell to close the contract as there isn’t any intrinsic value and the time value component has completely diminished. Therefore, the contracts will likely expire from your account as worthless.

scenario three

Your long put position breaks even when the stock price is equal to the difference of the strike price and the premium paid. In this case, it's $100 (strike price) - $3 (premium) = $97. If ABC closes at $97 at expiration, you neither gain nor lose money. Your option should be worth only its intrinsic value.

In this scenario, you hold an in-the-money option at expiration, you should be able to close the contracts on the market for the executable value of $3 per share. Remember, executable valuable represents the contract’s intrinsic value.

Lesson 2: Strategy | Long Puts

Holding a long option on the day of expiration

It is important to note in these examples the option was held on the day of expiration. This adds another layer of risk as in-the-money options will auto-exercise/assign on the day of expiration as means to capture any value contained within the option. If your account cannot support the sale of 100 shares of ABC at $100 per share (possibly resulting in a short position), you may create a position not permitted in your account, which requires additional monitoring.

Before expiration, the value of your long put option will fluctuate with changes in the stock price, implied volatility, and time depletion. If ABC declines above $100 but falls short of your $90 price target, your option may still have some value. Your gain or loss will depend on the current market price of ABC compared to the strike price and the remaining time to expiration. Therefore, it is prudent to consider the external factors that affect your options price in addition to your sentiment of the underlying security.

By understanding these scenarios and how they apply to your long put option, you can make informed decisions, set realistic price targets, and manage your risk effectively when implementing this bearish strategy.

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Strategy Lesson 2:

Knowledge Check

Lesson 2: Strategy | Long Puts

Knowledge Check

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What is the primary objective of employing a long put strategy?

(Select an answer below)

Lesson 2: Strategy | Long Puts

Knowledge Check

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Holding an option on the day of expiration generally contains no time value.

(Select an answer below)

Lesson 2: Strategy | Long Puts

Knowledge Check

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What external factors can impact the value of a long-put option before its expiration?

(Select an answer below)

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Congratulations!

You have completed Simple Options Strategies - Lesson 2:

Strategy | Long Puts

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