Long Put Strategy: A complete guide for beginners

What is Long Put Strategy?

When it comes to trading options, the Long Put is a versatile and powerful option strategy for investors who anticipate a decline in the price of an underlying asset. Whether you’re an experienced trader or new to options trading, understanding the ins and outs of Long Puts can enhance your trading toolkit.

Long Put options give the buyer the right, but not the obligation, to sell shares of the underlying asset at the strike price on or before expiration. Think of it as selling your stock with the option to buy it back later. Each contract is equivalent to selling 100 shares of stock but requires less capital, and the downside risk is limited to the option contract’s cost. It’s like dancing with the devil while keeping your toes intact.

When to use a Long Put Strategy?

A long put is purchased when the buyer believes the price of the underlying asset will plummet, at least enough to cover the cost of the premium, before the expiration date. It’s like betting on the end of the world: if it happens, you profit; if not, well, you’ve just invested in a bunker.

Farther out-of-the-money strike prices will be cheaper but have a lower probability of success. The farther the out-of-the-money strike price, the more bearish is the sentiment on the asset’s future.

Setting up a Long Put

To set up a long put, an investor purchases a Put Option contract. The cost to enter the trade is called the Premium. Factors that mess with this cost include the strike price relative to the stock price, time until expiration, and volatility.

Typically, put options are more expensive than their call option counterparts. This pricing skew exists because investors will pay more to protect against downside risk when hedging positions. It’s like buying flood insurance in a town built on quicksand.

Payoff Diagram of a Long Put

The payoff diagram is as straightforward as your ex’s breakup text. Your maximum risk is the option’s premium, and your profit potential is limitless until the stock hits zero. You break even if the stock price at expiration is below the strike price minus the premium.

Example: Purchase a long put option with a ₹1000 strike price for ₹50 premium. The maximum loss is the premium paid, i.e ₹50 , but profit potential is boundless until the stock reaches $0. However, the stock must fall below ₹950 at expiration to realize a profit.

Here’s the Long Put Option graph:

Exiting a Long Put

Get out anytime before expiration with a sell-to-close (STC) order. If you sell it for more than you paid, you’re winning. If not, tough luck. At expiration, if you’re in-the-money (ITM), you can exercise the option and sell 100 shares at the strike price. If you’re out-of-the-money (OTM), the contract is as worthless as a fake ID at a liquor store, and you eat the full loss.

Impact of Time Decay on Long Put

Time decay, or theta, erodes an option’s value as expiration looms. Options with more time until expiration are pricier due to the greater potential for price movement. As time dwindles, the option’s price declines, working against the buyer. It’s like watching your life savings vanish in the Casino – every second costs you, and all you’re left with is a sense of doom.

Impact of Implied Volatility on Long Put

Implied volatility is the market’s way of saying, “Get ready for some chaos.” Higher volatility means pricier options because everyone’s expecting wild swings. Imagine being on a roller coaster – the scarier the ride, the higher the thrill (and the cost), but if the ride suddenly smooths out, so does your excitement (and profit).

Adjusting a Long Put

When your long put starts to stink, you can turn it into a bear put spread. Here’s how:

• Original Setup: You’re holding a single long put option.
• Adjustment: Sell a put option at a lower strike price.
• Benefit: This reduces your overall cost and lowers the break-even point.
• Drawback: It caps your maximum profit potential.

Example:

• Initial: Bought a ₹1000 put for ₹50.
• Adjustment: Sold a ₹900 put for ₹30.

Calculations:

• Maximum Loss: Initial premium paid – Premium received from selling the put = ₹50 – ₹30 = ₹20.
• Maximum Profit: Difference in strike prices – Net premium paid = (₹1000 – ₹900) – (₹50-₹30) = ₹100 – ₹20 = ₹80.
• Break-even Point: Strike price of the long put – Net premium paid = ₹1000 – ₹20 = ₹980

Rolling a Long Put

To extend a trade’s duration, you can roll the long put by selling-to-close (STC) the current position and buying-to-open (BTO) a new option with a future expiration.

Example:

• Initial: ₹1000 put expiring in March bought for ₹50.
• Adjustment:
  • Sold the March put option before expiry for ₹20 (net loss ₹30).
  • Bought April ₹1000 put for ₹70.

Calculations:

• Net Loss on Original Position: Initial premium paid – Premium received from selling = ₹50 – ₹20 = ₹30.
• Total Cost after Rolling: Net loss on original position + Cost of new put option = ₹30 + ₹70 = ₹100.
• Break-even Point: Strike price of the new put – Total cost = ₹1000 – ₹100 = ₹900.

So, after rolling:

• Total Cost: ₹100
• Max Loss: ₹100
• Break-even: ₹900

Hedging a Long Put

You can hedge a long put by buying a call with the same strike price and expiration date, creating a long straddle.

Example:

• Initial: ₹1000 put bought for ₹50.
• Adjustment: Bought ₹1000 call for ₹50.

Calculations:

• Total Cost: Cost of put option + Cost of call option = ₹50 + ₹50 = ₹100.
• Break-even Points:
  • Upper Break-even: Strike price + Total cost = ₹1000 + ₹100 = ₹1100.
  • Lower Break-even: Strike price – Total cost = ₹1000 – ₹100 = ₹900.

So, after hedging:

• Total Cost: ₹100
• Max Loss: ₹100
• Break-even Range: ₹900 to ₹1100

Synthetic Long Put

Another advanced strategy is creating a synthetic long put by combining a short stock position with a long call option.

Example:

• Action: Short ₹1000 worth of stock and buy a ₹1000 call option for ₹50.
• Result:
  • Downside risk is limited to the call option’s strike price.
  • Profit potential is limited to the difference between the sale price of the short stock position and the call option premium paid.

Conclusion

Long Put option is a strategic tool for capitalising on anticipated declines in asset prices, offering limited risk and potentially unlimited profit. While it involves careful consideration of factors like strike price, time decay, and implied volatility, it provides a more controlled approach compared to short selling.
With options for adjustments and hedging, such as bear put spreads and synthetic puts, it’s a flexible strategy for both hedging and speculative purposes.