Skill Sheet: What You Will Learn Here
- What is a long put option?
- When to buy a long put
- Which put option to buy
- Factors to consider before initiating a long put trade
The entry level strategy for traders with a bullish view on the market is a long call. Likewise, a bearish view entails a Long Put trade. Buying a Put option is also an entry-level trade for hedgers.
Puts are bought by investors who feel that the market is set to fall and they would like to protect their portfolio.
Since the market falls are generally fast and short-lived, buying puts offer investors good short-term profit opportunities.
The alternative to buying a put option is selling a stock short. But selling a stock short carries with it the possibility of unlimited risk, compared to limited loss in options.
To understand the potential of a Long Put trade, let’s take a closer look at it.
Long Put trade
A long put occurs when a trader buys a put option. The reason for buying a put option is that the trader feels that the underlying asset may fall.
The trader stands to profit if the underlying falls, but can lose if the underlying remains flat or moves higher.
Basics – What is a Put Option?
A long put gives the buyer of the Put option the right to sell the underlying stock at the desired strike price. As the market keeps on falling the value of the Put option rises.
The buyer of a put option gets the right, but not the obligation, to go short on an underlying asset at a certain price, called the strike price, on or before the expiration date. If the underlying price decreases, so does the value of the Put contract. Conversely, if it goes up, the price of the Put option decreases.
Note the keyword here is the “right but not the obligation” to sell the underlying stock.
The buyer of a put option, in order to buy the right, pays a premium to the seller of the put contract. The buyer of the option can close his trade at any point in time by selling the option in the market or allowing it to expire worthless.
The buyer of a Put option needs to keep in mind three important points before entering the trade.
The first is the Strike price, which is the pre-determined price at which the underlying asset will be exchanged.
The second is the Expiration date or the date at which the contract is settled or expires worthless.
Finally, the Premium paid for buying the option has to be considered.
Payoff diagram of a Long Put Option
Let’s take an example. Suppose, Nifty is trading at 18,812 and a Long Put trade is taken by buying a 18800 Put for September 29, 2022 expiry.
Since the market is trading at 18,812, an 18,800 Call is an at-the-money (ATM) option.
The premium paid for creating the position was Rs 94 and the value of holding the position is Rs4,700.
The maximum loss to the trader in creating the position is Rs4,700.
The trader will break even when the market crosses the strike of his option, plus the cost of buying the call option.
Breakeven = 18,800 – 94 = 18706.
When to initiate a Long Put trade?
A trader will create a Long Put trade when he expects the underlying to be bearish.
Fear is considered a more powerful emotion between fear and greed. Thus, the drop would be sharp and fast when the market falls. This is one of the reasons why more traders prefer buying a Put option.
Option sellers are indeed correct in their trades more often than not. Even if the market does not move in the direction they have bet on, it will be profitable because of the characteristic of an option losing its value over time.
This restricts the situations under which a Long Put trade can be created.
Most traders initiate a Long Put trade on an intraday basis and square off their positions by the end of the day. Some traders also buy Put options to take the Buy Today Sell Tomorrow (BTST) trade. Exposure to the market for a short time has a limited effect on option decay.
The Long Put strategy is preferred by scalpers and momentum traders who are in the market for a short duration of time.
Professional traders prefer taking a Long Put trade when volatility is very low. When the Implied Volatility Percentile (IVP) or the Implied Volatility Rank (IVR) is very low, they create a Long Put trade.
Which Put Option to buy?
A long put strategy can be created by taking a position in any Put option strike. Many retail traders make the mistake of buying a Deep out-of-the-money (OTM) Put because it is cheap. For this option to be profitable the move has to be very fast and the market has to go a long distance.
The selection of the strike is an important factor to consider. If the trader is expecting a surprise and strong move, only then does it make sense to take a position in a Deep OTM strike, else an ATM, a slight In-the-money (ITM), or a slight OTM strike is good enough to create the position.
Factors to consider in selecting the Put option strike price
Impact of underlying price change
Theoretically, a Long Put trade has to move in line with the underlying. However, this is never the case. The relationship between the underlying and the put option is loosely dependent on the value of the option Greek called Delta.
Thus, if an option has a Delta of 0.20, then for every 100 points move of the underlying the option will move by 20 points.
Depending on the distance the trader expects the market to move, he can select the option strike price and pick up the one offering maximum returns.
Impact of volatility
When it comes to buying options, volatility is a friend. A rise in volatility will increase the price of the option. Traders enter a Long Put trade when they see that volatility is near its lowest point in a year.
Impact of time
Time is an enemy of the option buyer. With time the value of the option deteriorates. Thus, a Long Put option trade can be taken when the trader expects a sharp price burst. The Long Put trade can end up in a loss even if the direction is right but has failed to cross the breakeven point by the time of expiry.
Things to remember
Buying a Long Put is an indication of the investor’s bearishness. It is also an entry-level trade for hedgers.
A long put gives the buyer of the Put option the right to sell the underlying stock at the desired strike price. As the market keeps on falling, the value of Put options rises.
The alternative to buying a put option is selling a stock short. However, this strategy carries with it the possibility of unlimited risk compared to a limited loss in options.
The buyer of a Put option needs to remember three important points before entering the trade — the Strike price, the Expiration date, and the Premium paid for buying the option.
The Long Put strategy is preferred by scalpers and momentum traders who are in the market for a short duration of time. Professional traders prefer taking a Long Put trade when volatility is very low. A rise in volatility will increase the price of the option.
Time is an enemy of the option buyer. So, with time the value of the option deteriorates.