Trading options can be risky, but for investors who want to learn how to trade options, they can be a great way to accelerate your portfolio profits without a large amount of capital. There are two types of options: calls and puts. Long call option buyers expect the underlying stock or index to trade higher, while long put buyers expect the stock or index to move lower.
These long call and long put options allow investors to profit during either up or down moves. While most options traded are call options, investors who want to also profit from down markets need to understand “The Long Put Option.”
A put option allows the buyer to sell or “put” the stock back to the seller at a certain price (the strike price) by a certain time period (the expiration). The put option buyer’s cost is called the premium and it is determined by how far away the strike price is from the current price of the underlying stock, plus how far away in time the expiration date is from the current date. The farther away in price and time, the cheaper the option due to the greater amount of uncertainty.
The long put is a bearish play on the stock. It is like selling the stock short, but with great advantages in both cost and risk for the smaller investor.
When you sell a stock short, you are selling a stock you do not own, by borrowing the shares from a broker, with the anticipation of buying them lower. Short selling a stock requires a margin account with enough capital to provide collateral to borrow the shares, plus the ongoing interest cost. The long put does not have these hefty costs.
The other advantage for investors utilizing a long put strategy is the drastic decrease in risk. Theoretically, a short seller has unlimited risk as a stock could rise forever (think Amazon and Tesla!).
The risk to the long put purchaser is limited to the initial premium paid. If the stock trades higher than the strike price during and through the expiration date, the options will expire worthless and the investor will only lose the premium they paid for the option.
However, while the risk is limited, investors must understand that if the options expire with no value, the entire investment in the long put option can be lost. The long put strategy is therefore a low cost method to profit from a down move with a limited and certain risk.
The long put strategy works best with stocks where investors expect near-term steep share price declines. Let’s go through the mechanics of a long put utilizing a currently popular stock, AMC Entertainment Holding (symbol AMC).
AMC is a movie theatre chain with declining revenues and high fixed costs during the pandemic. Without a change in company fundamentals, a sharp rally in the stock price occurred at the end of January.
This surge was prompted by Reddit’s WallStreetBets online forum, following their success pushing heavily shorted Gamestop’s stock to ridiculous heights by creating a “short squeeze” where hedge funds already short the stock were forced to pay up in the market to meet the margin calls and prevent further losses, and fueling a “melt up.”
AMC went up over 300% – $5 to $15 – in a matter of days. And while vaccinations are slowly being distributed nationwide, the fundamental outlook for AMC has not materially improved. It certainly looks like an attractive long put candidate!
For simplicity, AMC’s current price at the end of January was $15. Let’s say we bought one $8 put expiring on March 26th with a $1 premium.
As each option contract equals 100 shares, the total cost is $100. The breakeven price would be $7 ($8 strike price less $1 premium paid). AMC would need to drop below $7 in order to make a profit. At the beginning of February, AMC’s stock price in fact did drop back to about $5 and the long put was worth $1.50. The profit was $50 per option contract with a 50% return in less than one month. Not bad!
Now, let’s take a look at a different scenario, where we go farther out the time horizon in order to pay less in premium. In January, the June AMC $8 put was trading at $0.50. The stock falls back to $5. However, the June put does not go up in value. This is due to the longer timeframe, which increases the risk for another rally.
This is the single biggest mistake many long call and long put option investors make: going too far out in time or strike price in an attempt to “hit a home run.”
While they may be right on the near-term stock move, the option does not rally and expires worthless. In order to ensure correlated option price movements, investors should not go too far out on either price or time.
In Summary
A long put strategy allows investors to take advantage of downward moves in stocks or indices with minimal capital outlay and limited risk. During volatile markets, they are a valuable tool to increase the profits within your portfolio.
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