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Long Put

Description

Description

Steps to buying a Put

  1. Buy the longer term Deep ITM put
  • Remember that for option contracts in the US, one contract is 100 puts. So when you see a price of $1.00 for a put, you will have to pay $100 for one contract.
  • For option contracts in the UK, one contract is for 1,000 shares, so if the option price is $1.00 you will pay $1,000 for one contract.
  • For S&P Futures options, one contract is for 250 futures, so if the option price is $1.00, you will pay $250 for one contract.

Steps In

  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV)
  • Try to ensure that the trend is downward and identify a clear area of resistance


Steps Out

  • Manage your position according to the rules defined in your Trading Plan
  • Do not keep the position into the final month before expiration
  • If the stock rises above your stop loss, then exit by selling the puts.

Context

Your Outlook

  • Bearish - you are expecting a fall in the stock price

Rationale

  • To make a better return than if you had simply sold short the stock itself. Do ensure that you give yourself enough time to be right; this means you should go AT LEAST 6 months out, if not 1 or 2 year LEAPs. If you think these are expensive, then simply divide the price by the number of months left to expiration, and then compare that to shorter term put prices. You will see that LEAPs and longer term options are far better value per month and they give you more time to be right, thus improving your chances of success. Another method is to buy only deep ITM options.

Net Position

  • This is a net debit trade because you are paying for the put option
  • Your maximum risk is limited to the price you pay for the option
  • Your maximum reward is unlimited until the stock falls to zero, whereupon your maximum reward is the strike price less the premium you paid for the put.

Effect of Time Decay

  • Time works against your bought option. So give yourself enough time to be right.
  • Don't be fooled by the false economy that buying shorter dated options are cheaper. Compare a one month option to a 12 month option and divide the longer option price by 12. You will see that you are paying far less per month for the 12 month option.
  • Give yourself time to be right; at least 3 months, preferably longer..

Appropriate Time Period to Trade

  • 6 months minimum
  • 12 months is better
  • 24 months is the safest

Risk Profile

Selecting the Stock

  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV)
  • Try to ensure that the trend is downward and identify a clear area of resistance
  • Use the Analyzer to verify current market data and calculations

Selecting the Option

  • Choose options with adequate liquidity, open interest should be at least 100, preferably 500
  • Strike: look for look for either the ATM or ITM (higher) strike above the current stock price
  • Expiration: give yourself enough time to be right; remember that time decay accelerates exponentially in the last month before expiration, so give yourself a minimum of 3 months to be right, knowing you'll never hold into the last month. That gives you at least 2 months to be right.


Maximum Risk
  • Limited to the amount you pay for the put option (premium)
Maximum Reward
  • Unlimited up to the strike price less the amount you paid for the put. Before expiration this could actually be more because of Time Value.
Breakeven
  • The put exercise (strike) price less the premium you paid for it

The Greeks

The Greeks

Expiration
Today - 6 months
Time(t) - 1 month

Theta

Theta is negative, illustrating that Time Decay is harmful to the position. Notice how Theta Decay is at its most harmful when the position is ATM.

Delta

Delta (speed) is negative and falls as the asset price falls below the strike price. Notice how Delta is zero when the position is deep OTM, accelerates inversely exponentially when the position is ATM, and stabilises to minus one (per contract) when the position is deep ITM.
LongPut

Vega

Vega is positive, illustrating that volatility is helpful to the position. Notice how volatility is at its most helpful when the position is ATM.

Gamma

Gamma (acceleration) is always positive with a Long Put and peaks when the position is ATM. Notice how Gamma approaches zero when the position is deep ITM or OTM.

Rho

Rho is negative, illustrating that higher interest rates would be harmful to the position.

Exiting the Position

Exiting the Position

  • Sell the options you bought

Mitigating a loss

  • Use the underlying asset or stock to determine where your stop loss should be placed.

Pros and Cons

Advantages

  • Profit from declining stock prices
  • Leverage of returns
  • Flexibility of strikes and expirations
  • Capped downside

Disadvantages

  • Potential 100% loss if badly chosen strike and expiration. Give yourself enough time to be right and do not buy OTM.
  • High leverage can be dangerous if the stock rises