Long Put Option Strategy

‌A long put option strategy entails purchasing a put option by itself. Investors with an investment objective of speculation and capital preservation utilize the long-put option strategy. A put option gives the investor the right to sell a stock at the strike price within a specified time-period. The put option gives the investor flexibility to sell the stock at a later point in time if the price declines in value. For this, the investor pays a premium for a put option which gives the right to sell 100 shares of stock.

The maximum upside potential in a long put is the strike price less the premium. The maximum potential loss is 100% of the amount invested in the long put option. A long put option strategy therefore requires a considerable level of risk tolerance. An investor who has a bearish outlook that anticipates the stock price to decline beyond a certain price by a set-date utilizes a long put option strategy.

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Let’s See an Example:

An investor anticipates that the stock price of EIO will decline in the next 3 months. EIO trades at $10 while a 3 month put option with the $10 strike price trades at $2.

The investor buys one EIO put option at the $10 strike price with 3 months until the expiration date for a premium of $2.

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The maximum potential profit is the strike price of $10 less the $2 premium received multiplied by 100 shares. This is calculated as follows:

Maximum Profit per Option = (Put Option Strike Price - Premium) x 100 shares

$800 = ($10- $2) x 100 shares

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The maximum potential loss is the premium of $2 paid for the put option multiplied by 100 shares. This is calculated as follows:

Maximum Loss per Option = Premium Paid x 100 shares

$200 = $2 x 100 shares

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The breakeven point is the $10 strike price of the option less the $2 premium. This is calculated as follows:

Break Even Point = Strike Price - Premium Paid

$8 = $10 - $2

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The profit and loss of the long put option strategy until the expiration date is depicted in the chart below.

The chart shows the potential profit and loss on the y-axis versus the corresponding stock price in the x-axis until the expiration date.

If EIO trades remains above $8 and beyond, the investor will take a loss anywhere between $0 and $200. If EIO trades fall below $8, the put option strategy becomes profitable with a potential maximum gain of $800 if the price goes to zero. The breakeven point is $8, which is the strike price of $10 less the premium paid of $2.

If EIO falls below anywhere between $10 and $0 during the duration of the option contract, the long put holder can exercise the option. This means the investor would sell 100 shares of EIO at $10. If the investor holds shares of EIO long, the shares would be sold at $10. If the investor does not hold shares of EIO, this means that he would acquire a short position of EIO. In order to acquire a short position, however, the investor must have a margin account, at least $2,000 in equity, and sufficient equity to hold the short position in EIO. If the investor wishes to capitalize from the decrease in EIO’s share price without having to exercise the option, he can sell the option at a gain once the price falls below $8 a share.

If EIO remains above $10 the option will expire worthless and the investor permanently loses the $200 invested.

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