Long Put Definition Example Vs Shorting Stock

Long Put Definition Example Vs Shorting Stock

Long Put: Definition, Example, Vs. Shorting Stock

With over 20 years of experience in the financial services industry, Tim Smith is a writer and trader.

What Is a Long Put?

A long put is the purchase of a put option, typically in anticipation of a decline in the underlying asset. The term "long" refers to the trader’s action of buying the option with the hope of selling it at a higher price later.

Traders may buy a put option for speculation, betting that the underlying asset will fall and increase the value of the option. It can also be used to hedge a long position in the underlying asset, offsetting potential losses.

Key Takeaways

  • A long put is a bearish position that involves buying a put option.
  • Investors go long put options to profit from a decrease in a security’s price.
  • Investors use long put options for speculation or to hedge against downside losses.
  • A long put options strategy limits downside risk.

Understanding a Long Put

A long put has a strike price, which is the price at which the put buyer can sell the underlying asset. For example, if the strike price is $50 and the stock drops to $20, the put option allows the trader to sell the stock at the higher price. If the stock rises and remains above $50, the option becomes worthless as it is not beneficial to sell at $50 when the stock is trading at a higher price.

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If a trader wants to exercise the right to sell the underlying asset at the strike price, they can choose to do so. However, they can also exit the option before expiration by selling it.

A long put option can be exercised early or expire in the money for American options, while European options can only be exercised at the expiration date. If the option is exercised early or expires in the money, the option holder will be short the underlying asset.

Long Put Strategy vs. Shorting Stock

A long put can be a favorable strategy for bearish investors instead of shorting shares. Shorting stock carries unlimited risk and limited profit potential. A long put option has limited profit potential and risk, as the maximum value increase is until the underlying stock reaches zero. The advantage of a put option is that the risk is limited to the premium paid for the option.

The drawback of a put option is that the price of the underlying asset must fall before the option’s expiration date, or the amount paid for the option is lost.

To profit from shorting stock, a trader sells at a certain price to buy it back at a lower price. Put options work similarly: if the underlying stock falls, the put option increases in value and can be sold for a profit. Exercising the option puts the trader short in the underlying stock, requiring them to buy the stock to realize the profit.

Long Put Options to Hedge

A long put option can also hedge against unfavorable moves in a long stock position, known as a protective put or married put.

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For example, an investor holds 100 shares of Bank of America Corporation (BAC) at $25 per share but is concerned about a potential drop in the stock. To hedge against this, the investor buys one put option with a strike price of $20 for $0.10 per share, which expires in one month.

The hedge limits the loss to $500 ($25 – $20 x 100 shares) minus the premium of $10 paid for the put option. Even if Bank of America falls to $0, the maximum loss for the trader is $510, as the put option covers losses below $20 in the stock.

Example of Using a Long Put

Assume Apple Inc. (AAPL) is trading at $170 per share, and you predict a 10% decrease before a new product launch. You purchase 10 put options with a strike price of $155 for $0.45 per share. The total cost of your long put options position is $450 + fees and commissions.

If the share price of Apple falls to $154 before expiry, your put options are worth $1.00. You can exercise them, shorting 1,000 shares of the stock at $155 and buying it back at $154 to cover your position.

Your long put options position is now worth $1,000 (less fees and commissions), resulting in a profit of 122% compared to the 9.4% fall in the underlying stock price.

If Apple shares rise to $200, the 10 option contracts would expire worthless, resulting in a loss of your initial cost of $450.

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