What is a long put option?

08/10/2024 - 9:00AM CEST

Options strategies – long put
Benefits, risks and examples of a long put option.

The long put option strategy anticipates a decline in the price of an underlying asset. This strategy allows for significant profit potential with limited risk, making it an attractive choice for bearish market conditions. This article explores the fundamentals of the long put option strategy, its benefits and risks, and how to effectively implement it.

What is a put option?

A put option is a financial contract that gives the holder the right, but not the obligation, to sell a specified quantity of an underlying asset at a predetermined price (the strike price) within a set period. The buyer of the put option pays a premium to the seller for this right.

In return, the seller of the option has the obligation to buy, upon the request of the buyer, a specified quantity of an underlying asset at a predetermined price (the strike price). This strategy is known as a short put option.

Unlike a call option, which benefits from rising prices, a put option profits when the underlying asset’s price falls.

Both buyers and sellers of put options can terminate either their right or obligation by a reverse (closing) transaction.

Understanding the long put option strategy

A long put option strategy involves purchasing put options with the expectation that the underlying asset’s price will decline. This bearish strategy allows the investor to capitalise on downward price movements, providing an opportunity for significant profits while limiting potential losses to the premium paid.

Key components of a long put option

Premium
The price paid for the option.
Strike price
The predetermined price at which the holder can sell the underlying asset.
Expiry date
The date by which the option must be exercised or will expire worthless.

Advantages of the long put option strategy

Limited risk
The maximum loss is limited to the premium paid, providing a defined risk strategy.
Leverage
Put options provide leverage, allowing investors to control a larger position with a smaller capital outlay compared to short selling the stock outright.
Profit potential
Significant profits can be realised if the underlying asset depreciates substantially, offering high reward potential for a relatively low initial investment.
Hedging
Investors can use long puts to hedge against potential declines in their existing stock positions, effectively reducing the overall risk of their portfolio.

Risks of the long put option strategy

Time decay
Options are wasting assets, meaning their value erodes over time, especially as the expiry date approaches. This time decay can work against the investor if the expected price movement does not occur quickly enough.
Volatility
While options can benefit from increased volatility, unexpected decreases in volatility can reduce the option’s value.
Out-of-the-money risk
If the underlying asset does not fall below the strike price by expiry, the option will expire worthless, resulting in a total loss of the premium paid.

Example of a long put option

Suppose you believe Company XYZ’s stock, currently trading at €50, will decline significantly over the next three months. You decide to purchase a put option with a strike price of €45 expiring in three months, costing €3 per share (options typically represent 100 shares, so the total cost would be €300).

Profit and loss potential of a long put

Breakeven point
The stock price at expiry must fall below the strike price minus the premium paid for the investor to break even. In this example, the breakeven price would be €42 (€45 strike price – €3 premium).
Potential profit
If the stock price falls significantly below the breakeven point, the profit potential increases. For example, if XYZ’s stock drops to €30, the profit would be (€45 – €30 – €3) x 100 = €1,200. As the stock price would not drop below €0 the profit is maxed at €4,200.
Maximised potential loss
The maximum loss is limited to the premium paid. In this case, the most the investor can lose is €300 if the stock remains above €45 by the expiry date.

Implementing the long put option strategy

Market analysis
Conduct thorough research and analysis to identify potential stocks or assets expected to decline in value. This can involve technical analysis, fundamental analysis, or both.
Select the strike price and expiry date
Choose a strike price that reflects your market outlook and an expiry date that allows enough time for the expected price movement to occur.
Monitor the position
Regularly review the position and market conditions. Be prepared to adjust the strategy if the underlying asset’s price movement or volatility changes significantly.
Exiting the position
Decide in advance your profit targets and loss limits. Consider exiting the position if the stock reaches your target price or if it becomes clear that the expected price movement will not occur within the desired timeframe.

Long put vs. other strategies

The long put option strategy is often compared with other strategies like short selling, long call options, and protective puts.

Versus short selling
A long put benefits from price declines and has limited risk (the premium paid), while short selling involves borrowing and selling the stock, which can carry unlimited risk and margin requirements.

Versus long call options
While a long call profits from price increases, a long put profits from price decreases, making it a complementary strategy for bearish market views.

Versus protective puts
Protective puts involve buying put options to hedge an existing stock position. A long put can serve a similar purpose but is used independently to speculate on price declines.

Practical tips to increase the possibility for success

Start small
If you’re new to options trading, start with a small position to understand how the market works and gain experience without taking on significant risk.
Use technical analysis
Technical indicators and chart patterns can help identify potential entry and exit points for the strategy.
Stay informed
Keep up with market news, earnings reports, and other factors that can influence the price of the underlying asset.
Risk management
Always be aware of your risk tolerance and never invest more than you can afford to lose.
Diversify
Don’t put all your capital into one position. Diversifying your investments can help spread risk and increase the chances of overall success.

The long put option strategy is a powerful tool for investors looking to capitalise on anticipated price declines in an underlying asset while limiting their downside risk. By understanding the key components, advantages, and risks, and by implementing the strategy with careful market analysis and risk management, investors can potentially achieve significant profits. As with any investment strategy, thorough research and prudent decision-making are essential for success in options trading.

Investing in the financial markets requires a deep understanding of various strategies to maximise returns while managing risk. Please consult your bank or broker for advice or read the Key Information Document to get a better understanding of all risks and costs involved.