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Long put stock option trading strategy

 

 

What is a long put option contract and why use it?

 

 

Investors and traders use the long put option trading strategy for various reasons ranging from participation in a stocks sell off to protecting an existing long stock position from a potential decline in price.

 

In this lesson we will be focusing on the pros and cons of purchasing a long Put stock option contract with and without owning the underlying stock.

 

Visit our option definitions page or the optionSimple.com bookstore for help with any terms you do not understand or to learn more about what we discuss in this section.

 

Purchasing a put option contract is a bearish option trading strategy that may be implemented when you think there is a possibility of a sharp or steady decline in the underlying stock price.

 

Put buying is a very popular speculative option trading strategy and should only be implemented when the appropriate consideration has been given to managing the risk of the position.

 

This means that you have a clear understanding why you are entering the trade. You should also have an exit strategy in place and are prepared to make any necessary adjustments on the position if need be.

 

The first thing you will notice is the similarities between the long put stock option strategy and the short stock strategy.

 

Both strategies are bearish and the trader expects the underlying stock price to go down.

 

A major benefit of the long put option position as opposed to shorting the underlying stock is regarding the capital requirement needed to initiate, as well as maintain the position.

 

The long put option strategy allows someone to participate in a stocks sell off for a fraction of the cost that it would take to initiate a short stock position. There is also no margin requirement when establishing and maintaining a put option position as there is when shorting a stock.

 

Another major difference between selling short a stock and the long put option strategy is the fact that a short stock position is not subject to an expiration. A short stock position can theoretically be held indefinitely, whereas, all stock option contracts expire at some point.

Books on shorting options and stocks.

 

Before incorporating the long put option strategy into your trading plan, it is extremely important to understand the nature of how a long put option position reacts to time passing.

 

As an option buyer, whether purchasing puts or calls, always scrutinize the price of option contracts, especially cheaply priced options nearing expiration.

 

It is very important to understand that put option contracts are priced the way they are for a reason. Every single day that passes by, put options loose extrinsic value, due to time decay.

 

In the final month (also known as the front month) prior to the expiration of a stock option contract, the contract tends to loose time premium at an accelerated pace (time value measured through the option Greek theta).

Books on the option Greeks and pricing.

 

Out-of-the-money, as well as near-the- money put options may appear to be a great value, but consideration must always be given to the option contracts expiration date.

 

At expiration, a long put option contract is only worth its intrinsic value (true value). This means that all 'out-of-the-money' and 'near-the-money' put options expire worthless, close doesn't cut it. Stock options are considered deteriorating assets for this very reason.

 

Not to say that purchasing out-of-the-money stock options should be avoided completely. There is plenty of opportunity in buying out-of-the-money options. You can essentially control the same amount of shares for a fraction of the cost.

 

A trader can make a significant amount of money if he or she owns a lot of cheap out-of-the-money options and actually gets the expected move in the underlying stock. But before tossing all of your trading capital into out-of-the-money stock options, understand the very real risk that the option contracts can expire worthless if at expiration the option is out-of-the-money.

 

You can't play the game if you are not in the game. Control your risk! or you will wind up paper trading for a few years. It is a tough lesson to learn and many good traders have lost fortunes because they slacked off on either risk management or betting to much, to soon.

 

The volatility of the underlying stock also plays a very important role regarding the long put stock option strategy.

 

Any rise in implied volatility (IV) will have a positive effect on a long put. A decrease in implied volatility levels will almost certainly hurt the value of a long put option position.

 

Implied volatility rises more quickly when there is a sell-off in the underlying stock. Though, it is very possible for the premium of a long put option to increase in value with a sharp move in either direction in the underlying stock price.

 

You will notice that more volatile stocks have more expensive option prices than less volatile stocks. This is because of higher Implied volatility levels.

 

(Theta and Vega are integral concepts regarding the pricing of put option contracts. They allow you to gauge how much of an options premium is due extrinsic value. Time value and implied volatility are a part of an option contracts extrinsic value.)

 

Theta and vega are known as option Greeks. The option Greeks are a set of inputs that an option pricing model, such as the Black-Scholes formula uses to determine a theoretical value for stock option contracts.

 

An understanding of the Greeks is essential to managing risk, as well as understanding why stock option contracts are priced the way that they are.

 

The above option graph illustrates holding a long put option position through the option contracts expiration cycle. Remember, at expiration, all that is left with regard to a put options premium is the intrinsic value of the put option contract.

 

(Always consider your risk to reward ratio before entering any trade.)

Books on risk management.

 

It is also worth noting that as an option buyer, you have the right to exit the option position at any point prior to the option contracts expiration. Many traders choose to take this route. Especially when there is still significant time premium left in the option price.

 

Another popular method for using a long put option is in combination with stock ownership. When used in this manner, the put option contract could be referred to as a "protective put" because it is protecting the underlying stock.

 

This is widely used to protect an investor from a decline in the price of their investment. The put option contract acts as a type of insurance policy for the investor on his or her long stock position.

 

The investor essentially caps his or her risk in the event that the stock price falls. Now, the risk profile has changed significantly. This approach is considered much safer than just owning the stock without the put option in place.

 

Many investors who own stock will purchase a long put option prior to an event, such as an earnings report or a broad based announcement that will effect the stock market as a whole. The long put can protect an investor that is long a particular stock because these announcements have the potential to cause a sell off in their stock position.

 

As you see there are many advantages to incorporating the long put option strategy into your trading activities. With proper risk management, as well as the ability to make the necessary adjustments, one will be well on their way to trading long put option contracts profitably.

 

Feel free to visit the optionSimple.com bookstore for more information regarding the long put option trading strategy. We offer over 1000 different titles on stocks, options, trading, risk management and much more. It pays to know your options.