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This chapter is from the book

1.3 Long Put

Proficiency

Direction

Volatility

Asset Legs

Max Risk

Max Reward

Strategy Type

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N/A

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Novice

Bearish

Long Put

Capped

Uncapped

Capital Gain

1.3.1 Description

Buying a put is the opposite of buying a call. A put is an option to sell. When you buy a put, your outlook is bearish.

ITM

In the Money

stock < put strike price

ATM

At the Money

stock = put strike price

OTM

Out of the Money

stock > put strike price

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Steps to Trading a Long Put

  1. Buy the put option.

    • Remember that for option contracts in the U.S., one contract is for 100 shares. So when you see a price of 1.00 for a put, you will have to pay $100 for one contract.
    • For S&P Futures options, one contract is exercisable into one futures contract. If the option price is 1.00, you will pay $250 for one futures contract upon exercise.

    Steps In

    • Try to ensure that the stock is trending downward, and is below a clearly identifiable area of resistance.

    Steps Out

    • Manage your position according to the rules defined in your trading plan.
    • Sell your long options before the final month before expiration if you want to avoid the effects of time decay.
    • If the stock rises above your stop loss, then exit by selling the puts.

1.3.2 Context

Outlook

  • With a long put, your outlook is bearish. You expect a fall in the underlying asset price.

Rationale

  • To make a better return than if you had simply sold short the stock itself. Do ensure that you give yourself enough time to be right; this means you should go at least six months out, if not one- or two-year LEAPs. If you think these are expensive, then simply divide the price by the number of months left to expiration and then compare that to shorter-term put prices. You will see that LEAPs and longer-term options are a far better value per month, and they give you more time to be right, thus improving your chances of success. Another method is to buy only deep ITM options.

Net Position

  • This is a net debit transaction because you pay for the put option.
  • Your maximum risk is capped to the price you pay for the put.
  • Your maximum reward is uncapped until the stock falls to zero, whereupon the maximum profit is the strike price less what you paid for the put.

Effect of Time Decay

  • Time decay works against your bought option, so give yourself plenty of time to be right.
  • Don’t be fooled by the false economy that shorter options are cheaper. Compare a one-month option to a 12-month option and divide the longer option price by 12. You will see that you are paying far less per month for the 12-month option.

Appropriate Time Period to Trade

  • At least three months, preferably longer depending on the particular circumstances.

Selecting the Stock

  • Ideally, look for stocks where the OVI is persistently negative for at least the last few days.
  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV).
  • The stock should be trending downward, and be trading below a clearly identifiable area of resistance.

Selecting the Options

  • Choose options with adequate liquidity; open interest should be at least 100, preferably 500.
  • Strike—Look for either the ATM or ITM (higher) strike above the current stock.
  • Expiration—Give yourself enough time to be right; remember that time decay accelerates exponentially in the last month before expiration, so give yourself a minimum of three months to be right, knowing you’ll never hold into the last month. That gives you at least two months before you’ll need to sell. Longer would be better, though.

1.3.3 Risk Profile

Maximum Risk

[Put premium]

Maximum Reward

[Put strike – put premium]

Breakeven

[Put strike – put premium]

1.3.4 Greeks

1.3.5 Advantages and Disadvantages

Advantages

  • Profit from declining stock prices.
  • Far greater leverage than simply shorting the stock.
  • Uncapped profit potential with capped risk.

Disadvantages

  • Potential 100% loss if the strike price, expiration dates, and stock are badly chosen.
  • High leverage can be dangerous if the stock price moves against you.

1.3.6 Exiting the Trade

Exiting the Position

  • Sell the puts you bought.

Mitigating a Loss

  • Use the underlying asset or stock to determine where your stop loss should be placed.

1.3.7 Margin Collateral

  • Being a long net debit strategy, there is no margin requirement per se because the risk of the trade is limited to the initial cost.

1.3.8 Example

  • ABCD is trading at $28.88 on February 19, 2015.
  • Buy the January 2016 30.00 strike put for 4.38.

You Pay

Put premium

4.38

Maximum Risk

Put premium

4.38

Maximum risk is 100% of your total cost here

Maximum Reward

Strike price – put premium

30.00 – 4.38 = 25.62

Breakeven

Strike price – put premium

30.00 – 4.38 = 25.62

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