Trading Strategy: Buying Put Options

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This article delves deeper into the trading strategy of buying put options (long put) in the options market.

What is a Long Put Strategy?

In options trading, buying a put option is a strategy that allows the holder to have the right (but not the obligation) to sell a specified amount of securities (typically stocks) at a predetermined price (strike price) on a specific date (expiration date).

Simply put, buying a put option is essentially the opposite of buying a call option. While buying a call option grants the holder the right to purchase stocks, buying a put option allows the holder to sell stocks. If buying a call option benefits from stock price increases, buying a put option profits from stock price decreases.

Therefore, holders of put options anticipate market declines. Some investors use the long put strategy to hedge against a portfolio, similar to how auto insurance protects your vehicle in case of an accident.

However, it’s essential to note that novice options traders are often surprised to learn that put options don’t always increase in value when stocks decrease. This is due to the time decay of the contract and the constant market fluctuations.

Long Put Strategy as Speculation

This example will focus on buying put options as speculation, as most traders use put options as a speculative tool in a bear market.

To better illustrate, imagine owning car insurance for someone else’s car. If the car is damaged, you’ll make money. If the car remains undamaged, you’ll lose the insurance premium paid. This analogy applies to buying put options, except instead of betting on the destruction of a car you don’t own, you’re betting that a specific stock/index will decrease in value.

Buying put options is an excellent speculative tool due to the leverage it provides. The actual cost incurred is typically only a fraction compared to the margin required for shorting 100 underlying assets.

However, this leverage comes with a drawback.

If you short a stock, and the stock remains unchanged for three months, you won’t lose anything. If you buy a put option that’s at a loss and expires in three months, and the stock remains unchanged during this time, you’ll lose the entire option premium. Put option holders need the market to decline significantly and quickly to realize profits, as time decay erodes the value of the contract and eats into your option buying costs.

As mentioned, Buying Put Options carries less risk than selling an equivalent amount of stock. Why? When you buy a put option, your risk is limited to the transaction fee paid. When you sell a stock, theoretically, that stock can increase indefinitely, and you can incur infinite losses.

Characteristics of Buying Put Options

Maximum Profit: The entire difference between the strike price and the option premium Maximum Loss: The option premium is the maximum loss Break-Even: Strike price minus the option premium Scenario 1

Suppose today is May 21. In two weeks, on June 4, the US Department of Labor will release the May employment report. You believe that the market is performing better than the actual economy and speculate that before and after this report, the market will undergo a correction.

Therefore, you are very bearish. However, your trading account has only $1,000 in buying power. You could short some stocks, but this wouldn’t give you the desired profit.

Recognizing the fantastic leverage benefits that options provide, you decide to buy a put option. Since you believe all stocks will decline, you choose to buy a put option on an SPY ETF (an ETF mimicking the S&P 500) that’s at a loss. The trade will be as follows:

Stock Price: $417 Put Option Price: $2.80 Put Option Strike Price: $410 Option Expiry: June 4 (13 days remaining) Maximum Loss: $280 Maximum Profit: $40,720 Break-Even Price: $407.20 Suppose two weeks have passed, and the employment report has been released. This is also the expiration date of the contract. Since the day you bought the put option until expiration, the stock has decreased by a total of $6 to $411.

Was our strategy good? Not quite. Because the stock closed above the strike price of $410, the option will expire worthless, and you will lose the entire option premium of $2.80, or $280.

You might wonder why this happened: The stock decreased after we bought the put option, from $417 to $411 – shouldn’t the put option make money when the stock declines?

It certainly does, but you’re not betting on whether the stock will decrease or not; you’re betting that the stock will decrease below a specific price on a specific day.

Every day the options don’t move in the direction you expect, time will gradually erode the value, and market volatility will eat into the transaction fee you paid. Most losing options will expire worthless for this reason.

Scenario 2

Now let’s try a scenario where the market plunges. SPY drops sharply to $401 per share. What does our put option contract mean in this case?

The easiest way to determine profit on a long put option trade is to first identify the breakeven point. Our breakeven stock price is $407.20 (strike price minus premium). Now, simply take the difference between the breakeven price and the current stock price. 407.20 – 401 = 6.2. We’ve made a profit of $620 for our put option contract!

Next, there are 3 ways investors can close the position:

If the contract is at a loss upon expiration, the contract will expire worthless, and investors don’t need to do anything. Sell the put option on the market before expiration If you don’t sell a profitable put option upon expiration, your broker may automatically exercise your right by (1) selling the stock (for stock options) or (2) settling in cash (for index options). Most options traders will close profitable put option positions before expiration to avoid having stock positions in their accounts.