The long put option strategy is a basic strategy in options trading where the investor buy put options with the belief that the price of the underlying security will go significantly below the striking price before the expiration date.
Buy 1 ATM Put
Put Buying vs. Short Selling
Compared to short selling the stock, it is more convenient to bet against a stock by purchasing put options as the investor does not have to borrow the stock to short. Additionally, the risk is capped to the premium paid for the put options, as opposed to unlimited risk when short selling the underlying stock outright.
However, put options have a limited lifespan. If the underlying stock price does not move below the strike price before the option expiration date, the put option will expire worthless.
"Unlimited" Potential
Since stock price in theory can reach zero at expiration date, the maximum profit possible when using the long put strategy is only limited to the striking price of the purchased put less the price paid for the option.
Unlimited
Profit achieved when: Price of Underlying = 0
Profit = Strike Price of Long Put - Premium Paid
Limited Risk
Risk for implementing the long put strategy is limited to the price paid for the put option no matter how high the stock price is trading on expiration date.
Premium Paid + Commissions Paid
Loss occurs when: Price of Underlying >= Strike Price of Long Put
Breakeven point
Strike Price of Long Put - Premium Paid
Example
Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock will fall sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ put option covering 100 shares.
Say you were proven right and the price of XYZ stock crashes to $30 at option expiration date. With underlying stock price now at $30, your put option will now be in-the-money with an intrinsic value of $1000 and you can sell it for that much. Since you had paid $200 to purchase the put option, your net profit for the entire trade is therefore $800.
However, if you were wrong in your assessement and the stock price had instead rallied to $50, your put option will expire worthless and your total loss will be the $200 that you paid to purchase the option.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.
Similar strategies
Out-of-the-money Puts
Going long on out-of-the-money puts maybe cheaper but the put options have higher risk of expiring worthless.
In-the-money Puts
In-the-money puts are more expensive than out-of-the-money puts but the amount paid for the time value of the option is also lower.