Making money in the markets isn’t always about the rising price of securities. If you see headwinds for a company, you can potentially profit from its stock’s downturn – and not only with a risky short sell. A long put options strategy can potentially reap the profits you want from a decline in stock price without putting a lot of your cash at risk.
Say you’re bearish on ABC stock, betting the market price will drop. You can deploy a long put options strategy and buy a put option on ABC company, allowing you to stake relatively little money for the potential in magnified gains that options provide.
Purchasing the put option gives you the right, but not the obligation, to sell ABC’s stock at a predetermined price known as the strike price. Selling the stock short can require much more capital, be complicated and pose unlimited risks of loss.
While your potential gains are limited in both scenarios, shorting has a greater risk of loss since a put option’s loss is limited to the premium you pay.
With a long put options strategy, if the price of ABC stock drops below the strike price, you can potentially make a profit. However, if the ABC stock price rises above the strike price, you likely won’t exercise, or sell, any underlying ABC stock, and you will lose the premium — the amount of money used to purchase the option.
What Is a Long Put Option?
When you buy an option, you get the right to sell or buy a security — stock or other asset — at a specific price by a certain date. But you have no obligation to do so. An options contract represents 100 shares of an underlying security.
One basic option is a call; another is a put. A call gives you the right to buy a security. A put gives you the right to sell a security. When it comes to puts, selling is a “short” position and buying is a “long” one. So with a long put options strategy, you are buying the option to sell a security, which limits your risk compared to holding the actual security.
For example, ABC company is trading at $30 a share, and you believe the price will drop to $27 a share. You decide to buy a put contract for $2, so the contract’s premium is $200 (Options contracts are for 100 shares and 100 shares * $2=$200). This options purchase may look like this: Long 1 ABC Aug 27 put @ $2. You are betting ABC’s stock will drop below $27 on or before the third Friday in August. (Note: The 27 here represents the strike price, not the 27th day of August.) If ABC’s price doesn’t drop below $27 before that day, the contract expires, and you lose the $200 premium you spent to open the contract.
But say the price declines to $23. You can go to the market and purchase ABC at $23 a share. Then, you can exercise your option and sell your shares at $27. With one contract, that’s 100 shares of ABC, earning you a profit of $400 (100 shares * $4), or $200 after you subtract your premium.
With a long put option, your maximum gain is the strike price minus your premium (in the unlikely case that the underlying security drops to $0). Your maximum loss is your premium.
How to Begin Trading Long Put Options
While options trading typically is left to more experienced investors, you can get started easily and with little capital. You must do your research, but here are the steps to getting started:
- Hire an options broker.
- Open an options account.
- Fund your account.
- Research securities options.
- Select your options.
- Make your trade.
Investors employ a long put options strategy for two reasons: speculation and hedging. They’re speculating the stock price will decline and hedging a long position on the underlying stock. If the stock falls, the long put can help offset the loss.
Put a Long Put Options Strategy to Work
When you short a stock, your possibly losses are technically unlimited, but long put options cap that loss. So this strategy is worth considering if you’re bearish on a stock.
A long put options strategy might not be as risky as short selling, but you still have risks. Just as quickly as you can see gains multiply, you can see losses wipe out your earnings and capital.
On the date of publication, Sarah Edwards did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
