Buying a put option is a welcomed alternative to short selling a stock. Although both strategies offer traders the chance to make a profit from a decrease in a market, only buying a put does so with limited risk.
A put option gives the buyer the right, but not the obligation, to sell 1,000 shares of an underlying security at a fixed price until the option’s expiry date.
A put option holder has the right, if he or she chooses, to sell the stock at a set price within a certain time period. The option writer has the obligation to fulfil that right.
Just like call options, put options come in various strike prices with a variety of expiry dates. However, unlike call options, if you are bearish (expect the stock price to fall), you might consider going long a put option. If you were bullish (expect the stock price to rise), you might consider shorting a put option.
Long Call Option Example
1 x Aug20 XYZ 25.00 Call @ 1.20
Gives the purchaser the right to sell…
100 shares of XYZ at $25 per share ($2500 total).
That right is good until…
Close of business the day before the last Friday in January 2020.
The cost to acquire that right is…
The premium of $45.00 (0.45 x 100 = $45.00).
Put buyers have limited potential to profit on a fall in price of an underlying stock (as the underlying can only fall to zero), but unlike short stock positions, risk is limited to the premium paid for the option. Since puts can typically be purchased for less than it would cost to short the underlying stock, it is an economical way to leverage trading capital in order to participate in a downward market movement. Be aware though, options are a wasting asset since their value declines as they approach expiry. Shorting the underlying stock has no expiry.
Going Long Puts
Long Put vs. Short Stock Risk Profile.
If you choose to buy or go long a put option, you are purchasing the right to sell the underlying security at a specific strike price on or before the specified expiry date of the option. The premium of the long put option will show up as a debit in your trading account (i.e., you will pay it out of your account).
Limited Risk: The maximum risk is limited to the premium paid for the put option.
Limited Profit: Limited potential to the downside beyond the breakeven. The put profit increases as the price of the underlying security falls below the strike price, but has a limited range as the underlying stock can only fall to zero
Breakeven: Put strike price – put premium
Risk Profile: Shows a limited profit below the breakeven (as the underlying can only fall to zero) and a limited loss above the breakeven equal to the premium paid to purchase the option.
This position is taken when the underlying stock is expected to go down in value. As the underlying stock falls, the long put becomes more valuable because it gives you the right to sell the underlying stock at the put strike price. That’s why you want to go long put options in a bearish or falling market.
The risk profile shown in Figure 15 shows how a long put option’s risk is limited to the cost of the premium, while a short stock comes with unlimited risk as the stock climbs above its initial price. Both trading instruments have limited profit potential as the underlying stock falls toward zero.
Going Short Puts
Short Put vs. Long Stock Risk Profile.
Shorting or writing a put option is risky. By writing a put option, you are selling someone else the right to sell 1,000 shares of the underlying security at the option’s strike price until the expiry date. In exchange, you receive a credit in the amount of the option’s premium. However, shorting a put option also comes with an obligation to buy the underlying instrument if the option holder chooses to exercises the option.
Limited, but High-Risk: Limited as the price of the underlying stock can only fall to zero. If the price of the underlying stock remains higher than the strike price of the put, you will not be in danger of the put being exercised. There is no reason for a put option buyer to exercise a put option when he or she can sell the underlying stock at a higher current market price. However, if the price of the underlying stock falls below the put strike price, the put may be exercised and assigned to the put seller. The put seller is then obligated to purchase 1,000 shares per contract at the put strike price.
Limited Profit: Limited to the premium received for selling the put option. By selling a put option, you will receive the option’s premium in the form of a credit into your trading account. The premium received is the maximum reward for a short put position. In most cases, you are anticipating that the short put will expire worthless by expiry.
Breakeven: Put strike price – put premium.
Risk Profile: Shows a profit limited to the put premium received and a limited loss below the breakeven (as the underlying stock can only fall to zero).
If your put option is exercised, you are obligated to purchase the underlying shares from the buyer of your short put option at the strike price sold. Experienced traders who choose to go short put options do so in a stable or bull market because the put will not be exercised unless the market falls. There is also a substantial margin requirement for shorting puts.
The risk profile in Figure 16 reveals the difference between how a short put provides limited reward and the long stock offers unlimited reward. Both trading instruments come with limited, but high risk, which is why we never recommend selling naked (uncovered) puts.
Put Strike Prices
As explained under call options, strikes for stock options come in multiples of 0.10, 0.25 and 0.50, depending on the underlying stock value as defined by the exchange.
The relationship between the strike price of a put and the price of the underlying security determines whether a put is in-the-money (ITM), out-of-the-money (OTM) or at-the-money (ATM).
Option vs. Underlying Price
Put Strike Price > Stock Price
In-the-Money (ITM) Option
Put Strike Price = Stock Price
At-the-Money (ATM) Option
Put Strike Price < Stock Price
Out-of-the-Money (OTM) Option
Call Option Moneyness.
A bearish trader may purchase a put (go long) because they expect the underlying stock to decrease in price. The trader will most likely make a profit if the market price of the underlying security decreases fast enough to overcome the put option’s time decay.
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