What is a long put option strategy and how does it work?

What is a long put option strategy?

A long put option strategy is set up by buying a 'put option' on an underlying asset. If the underlying asset falls in price, the price of the put option increases in value. A long put strategy can be a speculative position, or it can be used to hedge an existing long position. The downside is limited to the premium paid.

How does a long put option strategy work?

A put option increases in value when the underlying asset falls in value. You can go long on a put option either as a speculative position or as a hedging strategy for an existing long position. The increase in the value of the put option should offset some of the loss in the underlying long position.

A put option gives the holder the right – but not the obligation – to sell an asset at the strike price on or before the expiration date. You can choose from a list of strike prices and expiration dates depending on your view on the trade.

The cost to enter the trade is the premium paid – this represents your maximum loss. If the underlying security falls in value, the put option should increase in value. You can choose to sell the put option at a profit before expiry, or you can hold the put to expiry and receive the intrinsic value if the put option is in the money. The theoretical maximum profit is if the underlying security falls to zero.

The break-even level for a long put strategy is the cost of the premium paid, minus the strike price. If the security closes on the expiration date at or above the strike price, the option will expire worthless because it is out of the money. As there is no need to exercise the option, you would just let the option expire. The loss would be limited to the initial premium that you paid.

Pros and cons of a long put option

Advantages

• There is the potential for high profits, especially if the underlying asset falls significantly in price
• As the maximum loss is always limited to the premium paid, the strategy has limited downside. That is the key advantage of a long put strategy over a shorting security, which also allows you to benefit if the underlying asset falls in value. If you are short a security, however, your losses are theoretically unlimited if the asset rises in value
• A long put strategy can be used to hedge an existing long position, providing protection from the downside in the underlying asset
• It is flexible because you can choose the exercise price and expiry date to best suit your strategy

Disadvantages

• It has a limited time frame because the expiration date determines the duration of the trade. Timing the market can be difficult, even for professional traders. You will lose the premium paid if the price of the underlying asset does not fall sufficiently before the expiration date
• The value of options decreases over time. Each day that passes, the time value component of the option decreases, lowering the price of the put option
• Implied volatility estimates the expected price movement of an asset over a period of time and is a key component of option pricing. If the implied volatility is high when you buy the put option, a fall in the implied volatility will lead to a fall in the price of the put option

Example of a long put option strategy

If a company's share price is trading at $105 and you are bearish and think the share price will fall to $90, you could buy a put option with a $100 exercise price. In this example, the cost of the premium for the put option is $500.¹

If the share price is trading at $95 at expiry, the long put option strategy would be at the break-even level. You would receive back all the premium that you paid. If the share price closes below $95 at expiry, the long put option strategy would be profitable because the share price has moved below the break-even level. The lower the share price falls, the higher the profit. If the share price falls to zero, the maximum profit would be $9,500.

If at expiry the share price is trading at $100 or higher, the put option would expire out of the money. This means you would lose $500 – all the premium paid. That is the maximum loss, even if the share increases in price to $150.

If at expiry, the share price is trading between $95.01 and $99.99, the put option would be 'in the money' – but the put option strategy would still be loss-making overall because you would not have covered the premium paid. The closer the share price to $95.01, the lower the loss.

There is no need to hold the long put option until its expiration date. You're allowed to sell the put option at any time – either to take a profit or to cut your losses.

How to set a long put option

1. Do your research about the different option markets
2. Open a trading account or practise with a free demo account
3. Trade options using a CFD account
4. Select your market: you can trade options on shares, stock indices, forex and commodities
5. Choose your position size, exercise price and expiration date
6. Open the position and manage your risk

Research your market

Traders can choose from a huge number of markets to trade on using our award-winning platform. You can trade options using a spread betting or CFD account with us. Like shares, listed stock options can be traded on registered exchanges – some retail traders will do so via a broker. However, using a broker typically requires you to pay a commission, and you may have to deliver or take delivery of the underlying asset. We do not do this. With spread betting or CFDs, there is no commission paid on transactions, and all options are cash settled at expiry.

Learn about the differences between spread betting and CFD trading.

Trading options via CFDs

You can trade options using a CFD trading account. CFD is short for 'contract for difference'. CFDs are leveraged products. This means you don't own the underlying asset, but you're betting on its price movement. Your currency exposure and initial margin will vary according to the contract of the asset chosen.

Buying options using CFDs limits losses to the initial margin paid. Your wins or losses will depend on the outcome of your prediction. CFDs are popular with traders because you can offset losses on CFDs against profits for capital gains tax purposes.* Therefore, traders often use CFDs to hedge their positions.

Remember, trading with spread betting or CFDs comes with added risk attached to leverage. Your position will be opened at a fraction of the value of the total position size – meaning you can gain or lose money much faster than you might expect. It's also good to keep in mind that past performance is not an indicator of future returns.

* Tax laws are subject to change and depend on individual circumstances. Tax law may differ in different jurisdictions.

How to exit a long put option?

There are several ways to exit a long position.

• You can exit a long put strategy anytime before the expiration date by 'selling to close' the long put option. If the put option is sold at a higher price than you originally paid, then you make a net profit. If the put option is sold for a price lower than you paid, then you will make a net loss
• At expiration, you can let the option expire. Any proceeds, if the option has closed in the money, will be credited to your account. There is no need to exercise the option and take physical delivery of the underlying asset
• Adjusting a long put: Imagine that you are long a put with an exercise price of $100. You don't want to sell the put option because you think there is only downside to the underlying asset before expiration at $95. You can 'adjust' by selling a put with the same expiry date and an exercise price of $95. You will receive the premium from selling the $95 put option, reducing the cost of the overall trade. However, your maximum profit is now limited to the spread of the two exercise prices ($100 – $95), minus the net premium paid (cost of the $100 put, minus the premium received from selling the $95 put)
• Rolling a long put: If you still believe the underlying security is likely to fall in price, but the expiration date is near, you can roll the position forward. You will need to 'sell to close' the initial position and buy a new long put position with a later expiration date. This will increase the cost of the overall strategy

Long put option strategy summed up

• Being long a put option gives you the right but not the obligation to sell an asset at a certain price within a set time frame
• A long put option strategy is profitable when the underlying asset falls in value sufficiently to cover the cost of the premium. It can be used to speculate on an expected decline in the underlying asset or to hedge an existing long position
• Losses on a long put option strategy are limited to the premium paid, so some traders prefer going long a put to shorting an asset or security
• Time decay is one of the key disadvantages of a long put strategy, as the time value component of the option price falls each day – this lowers the price of the put option
• At expiration, there is no need to close the position – you can just let the option expire. The value of the option will be credited to your account

Sources

1. Long Put – Option Alpha