The Long Put Strategy – Betting on the Downside
Jim Graham
Americans are optimists; we think that everything is going to look better tomorrow, including stock prices. So we naturally tend to favor call options, because when the stock price goes up we will make a nice profit. In fact, when exchange traded options were introduced in 1973 there were no put options available, only calls! Put options on stocks didn't begin trading until four years later, in June 1977.
The fact is, however, that the stock markets (and the individual stocks they are comprised of) do not always go up. They can have long seasons of bearish activity. Buying put options allows you to profit when this happens.
When you buy a put option on a stock, you acquire the right to sell 100 shares of stock. This option is a contract that specifies the price (the strike price) you have the right to sell the stock at, and by what date (the expiration date). The put option buyer has the right to sell the stock at the strike price, but doesn't have to. The put option seller, on the other hand, has the obligation to buy the stock at the strike price if the put is assigned.
Most investors find it easier to understand calls, but the put gives the investor many advantages not available with calls. So the time spent learning about puts and how to use them properly is time well spent. Many of the option terms used are the opposite depending on whether they are used with calls or puts.
When talking about put options, in-the-money refers to a put whose strike price is higher than the current stock price. At-the money still describes an option whose strike price and stock price are the same, but an out-of-the-money put has a strike price that is lower than the current stock price. The out-of-the-money put option position has higher leverage and more risk compared to an at-the-money or in-the-money option.
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An option buyer can only lose the amount paid for the option; nothing more. With a call option, the profit potential is theoretically unlimited since there is no limit on how high a stock price can go. But there is a limit with put options, since the price of a stock can not go below zero. Still, that leaves lots of room to make a profit with most stocks.
The same qualities of leverage, limited risk, and large potential profits that make buying calls attractive apply to put options as well. Just remember, the option buyer's enemy is time decay. As each day goes by the option loses some of its value, so speculative put buying works best when you are working in a shorter time frame. The performance graph below for a long put position clearly illustrates the limited risk and big profit potential for this strategy.
The three lines illustrate how time decay affects the position with the solid line representing the possible outcomes on expiration day while the dotted line shows what should happen at the various stock prices today and the dashed line between them represents the theoretical performance of this option halfway between today and expiration.
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There are many different strike prices and expiration dates available for put options. Since options with different strikes and durations respond differently to price movements in the stock, the decision about which option to buy is important. In no way should a cheaper price influence your decision about which option to purchase. Remember, the cheaper option would be out-of-the-money (below the stock price), and buying them has a lower probability of success than buying at- or in-the-money options.
Also, remember that the time remaining before the expiration date is a key factor in the decision criteria. Time works against the option buyer as soon as the order is executed. Decide how long you think it will take for the stock to make the expected price move and then double it. That should give a reasonable idea of what expiration month to consider.
Finally, always know the current volatility situation by looking at a volatility chart. This allows you to know whether the options are historically cheap or expensive for that stock. If implied volatility is very high, you may want to consider buying deeper-in-the-money options. These options have less time premium, so they are not as sensitive to changes in volatility. You may also want to consider using a spread to reduce your volatility risk in that situation. While the potential rewards from buying puts as a stand-alone strategy are high, never forget that the associated risk is very high as well.
(ODD).
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