One of the very first strategies anyone generally meets when learning about options trading is the long put. However, its popularity does not mean that it is simple to understand and to use in order to profit from bearish markets. In this guide, we will learn what a long put is, how it works, when it should be used, and the potential risks involved. We will also provide an example trade to better illustrate the concept.
Key takeaways
- The long put strategy is a trade setup that consists of buying a put option on an underlying security. This strategy has an uncapped profit potential and limited losses.
- Time decay works against you in a long put, as the option’s extrinsic value decreases over time.
What Is a Long Put?
The first question we’ll answer is the usual one: what is a long put? A long put option is a strategy used by traders when they expect the price of an underlying asset to decrease. By purchasing a long put, the buyer gains the right, but not the obligation, to sell the asset at a predetermined price, known as the strike price, before the option expires.
Key Mechanics of a Long Put
- Purchase of a Put Option: The buyer pays a premium to acquire the option, which grants them the right to sell the asset at the strike price.
- Profit Potential: The lower the asset’s price falls, the higher the potential profit (notice that the profit will increase linearly, as we show in the “Long Put Payoff” section).
- Risk and Losses: The loss is limited to the premium paid for the option, making it a financially safer bet than directly shorting the asset.
Long Put Payoff
The payoff of a long put is essentially the difference between the strike price and the market price of the asset, minus the premium paid. If the market price falls below the strike price, the long put payoff can be substantial. Here is what the typical profit and loss (P&L) long put graph looks like:
As you can see from the long put graph above, there are two main features that should catch your attention:
- Limited Losses: Confined to the premium paid for the option.
- Uncapped Profit Potential: As long as the asset’s price continues to fall. Obviously, the underlying asset price cannot fall below $0, but it could still drop significantly. What matters here is that, as you can see from above, your profit will increase in a linear manner.
A Quick Long Put Example
Consider an investor who anticipates a decline in the stock of Company X, currently trading at $50. They purchase a long put option with a strike price of $45. If the stock falls to $40, the investor can sell at $45, profiting from the difference, less the premium paid.
In essence, the long put strategy is a relatively low-risk way to bet against market prices, providing a way to hedge against potential losses in other investments.
Now that you know what a long put is, let’s look at a more realistic long put example by leveraging our options screener.
A Real-Market Long Put Example
Let’s make things a bit more realistic with a long put example taken from a real-market case. Suppose you’re looking at QQQ, an ETF that tracks tech companies in the US, and you’re feeling bearish. Maybe the earnings season has you expecting tech companies to underperform, or you simply want to hedge against a potential market correction. Either way, you believe that a long put on QQQ might be a good strategy.
Setting Up the Long Put
Let’s say QQQ is currently trading at $500.16. You decide to purchase a long put option with a strike price of $475, expiring in one week. The P&L of the strategy – as found on our screener for options trading – would be the following:
This option is out-of-the-money (OTM), making it relatively inexpensive—you’d pay $0.43 per share. Given that options contracts usually involve 100 shares, your total cost would be $43. This small investment acts as an insurance policy for your portfolio.
As you can see in the long put graph above, your breakeven point would be $474.57. This is where your investment starts to pay off, as it’s where QQQ needs to fall for you to cover the cost of the premium.
Also, it is smart to review the historical price trends of QQQ:
Notice from the chart that QQQ has frequently traded around or below your breakeven point. Therefore, your strategy might be well-founded.
Potential Long Put Payoff
In a (hardly likely, but not 100% unlikely) scenario where QQQ drops by 10% within a week, your option would become highly valuable. With a 10% drop, QQQ would fall to $450.16, making your $475 put option deep in-the-money. Here’s how your long put payoff would break down:
- Stock Price: $450.16
- Strike Price: $475
- Profit: ($475 – $450.16) x 100 shares = $2,484
- Net Profit: $2,484 – $43 (premium) = $2,441
Understanding the Risks
While the profit potential seems tempting, it’s important to understand the risks. The primary risk here is losing the premium if QQQ doesn’t fall below the strike price by expiration. However, this loss is limited to $43, a manageable amount for the potential upside.
Long Put Strategy Benefits
As you saw on QQQ, there are a few evident benefits involved with the long put strategy:
- Limited Risk: Only the premium paid is at risk.
- Leverage: Ability to control a large position with a small amount of capital.
- Flexibility: The option to sell isn’t mandatory, allowing you to react to market changes.
In essence, this real-market example of a long put strategy on QQQ illustrates how option traders can potentially profit from declining markets or use it as a hedge against portfolio downturns. By keeping the costs low and risks limited, traders can position themselves to benefit from sudden market corrections. This approach provides a strategic edge, allowing traders to capitalize on market movements while maintaining a clear perspective on their financial commitments.
Advantages and Disadvantages of the Long Put Strategy
By this point, you should have already caught on a few pros and cons of the long put strategy. As we dig deeper, let’s lay out the specifics. The table below summarizes the main pros and cons you should know about the long put strategy:
Advantages
- Limited Risk: One of the standout benefits of a long put option is its limited risk. Your potential loss is restricted to the premium you pay for the option. This aspect allows traders to manage risk effectively, knowing exactly how much they might lose upfront.
- Profit Potential: Long puts offer a chance for significant profits if the underlying asset’s price drops below the strike price. While theoretically limitless, this profit hinges on the extent of the price drop. For traders anticipating a downturn, the profit potential can be enticing.
- Flexibility: The long put can serve as a core strategy or part of a more complex trading strategy. It offers flexibility, whether you’re hedging against losses or speculating on price declines. This adaptability makes it a favorite among options traders.
Disadvantages
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- Limited Time: A long put has a set expiration date. If the asset’s price doesn’t fall below the strike price before this date, the option can expire worthless. This time constraint requires careful management of your positions.
- High Premiums: Depending on the asset’s volatility or the time until expiration, long put options can be expensive. These high premiums can make achieving a favorable risk/reward ratio challenging, especially if the market doesn’t move as anticipated.
- A Decline in Implied Volatility May Hurt You: A sudden decrease in the implied volatility of the option (like the typical IV crush observed after earnings) can hurt the value of your option.
Other Things to Know About the Long Put Strategy
There are actually at least a couple of other important factors to consider when using the long put strategy. The table below sums up the effects of time decay and implied volatility on your long put position:
Time Decay and Long Puts
Time decay is a critical aspect of how a long put option is priced. Known as theta in the options world, time decay represents the erosion of an option’s value as it nears expiration. A long put derives part of its value from the time remaining until expiration.
As this time decreases, the extrinsic value—essentially the added value due to the option’s potential to make a profit—also declines. This means if you hold a long put without the asset’s price moving as expected, the option can lose value simply because it’s getting closer to its expiration date. So, while an option with a longer time until expiration may cost more, it also provides a greater chance for the underlying asset to move enough in price to be profitable.
Implied Volatility’s Impact
Implied volatility is another key factor influencing long put pricing. It reflects the market’s expectation of the asset’s price fluctuations. Higher implied volatility means a greater chance of significant price swings, which makes options, including long puts, pricier.
This is because there’s a higher probability of the asset moving past the strike price, potentially leading to a profitable payoff. On the flip side, if implied volatility decreases, the price of the long put option can drop. For those holding a long put, a rise in implied volatility before expiration can be beneficial, potentially increasing the option’s value even if the underlying stock price hasn’t changed much.
Can You Adjust and Roll a Long Put Effectively?
So far, we have focused on how to enter a long put position, but that does not mean that learning how to manage it isn’t equally important. Adjusting and rolling are two strategies that can help you optimize a long put for better outcomes.
Adjusting a Long Put
Adjusting a long put involves managing the position to minimize potential losses. One way to adjust is by converting a single-leg long put option into a bear put debit spread. This is done by selling a put option at a lower strike price. For instance, if you bought a $120 put option for $6.00, you could sell a $115 put option for $2.00 credit. This adjustment:
- Reduces the maximum loss to $400 (because $6 – $2 = $4, which multiplied by the usual 100 shares multiplier of an option contract gives $400).
- Caps the max profit at $100 if the stock closes below $115 at expiration (this is the price to pay to “rescue” your trade, you are giving up on the chance to have uncapped profits).
- Lowers the break-even point by $2.00 compared to the original long put graph.
This strategy helps lower the overall cost of the original position and decreases the break-even price, though it does limit profit potential.
Rolling a Long Put
Rolling is another method to manage a long put option, especially if you want to extend the trade duration. This involves selling-to-close the existing long put and buying-to-open a new one with the same strike price but a later expiration date. While rolling often incurs additional costs (debit), it provides more time for the trade to potentially become profitable. It’s a useful tactic if you believe the underlying asset will drop in price but hasn’t yet.
