Last updated on February 24th, 2022 , 06:14 am
| Long Put | Short Put | |
|---|---|---|
|
Market Direction |
Bearish |
Neutral and Bullish |
|
When To Trade |
Best for traders very bearish on a security |
Best for traders who believe a security will either stay the same or increase in value. |
|
Maximum Profit |
Strike price of the put minus the price of the put |
Credit received |
|
Maximum Loss |
Entire debit paid |
Strike price minus the premium received |
|
Breakeven |
Strike price minus the cost of the put |
Strike price minus the premium received for the put. |
|
Time Decay Effect |
As time passes, and both implied volatility and stock price stay the same, a long put will persistently shed value. |
As time passes, and both the implied volatility and stock price stay the same, a short put will shed value – which is desirable for short puts. |
|
Probability of Success |
Low |
High |
Long Put Explained
Long Put Definition: In options trading, a long put is a bearish trade that gives the owner the right to sell 100 shares of stock at the contract’s strike price on or before the options expiration.
Call options give the owner the right to purchase stock. Put options give the owner the right to sell stock.
Therefore, put options are bearish trades.
Beginners often compare buying puts with selling stock – this comparison is far from valid.
When you sell a stock, you profit when that stock falls in value, by any amount.
Put options, on the other hand, not only need the stock to fall to become profitable but the stock must also fall by a lot.
Let’s take a look at an example to understand why.
Long Put Option Example
Let’s say Apple (AAPL) is due to release earnings in 7 days. We believe AAPL will fall post-earnings.
However, we only have 1k in our trading account. With AAPL trading at $170/share, this won’t give us too much exposure by selling stock.
This is when options come in handy. Calls and puts typically have a multiplier of 100×1. This means that one contract represents 100 shares of stock. That’s a lot of leverage!
Let’s take a look at an options chain and choose our strike price.
AAPL Options Chain
| Put Strike Price | Premium (Cost) |
|---|---|
|
$170 |
$4.25 |
|
$165 |
$2.25 |
|
$160 |
$1.40 |
So let’s say we went ahead and purchased the $165 call for a debit of $2.25. Because of the multiplier effect of 100, the true cost of this trade is $225. Here are our trade details.
Trade Details:
Stock Price: $170
Strike Price: $165
Option Cost: $2.25 ($225)
Let’s first discuss how much we could make on this trade.
Long Put Maximum Profit: Strike price of the put minus the price of the put.
We bought the 165 put for $2.25, therefore, our max profit is (165-2.25) $162.75, or $16,275! This occurs when AAPL is trading at zero on expiration – unlikely!
What about the maximum loss?
Long Put Maximum Loss: Debit Paid.
So our max loss here is our debit paid of $2.25. Seems like a pretty good risk/reward scenario – but options trading is all about probabilities.
Let’s see how our trade actually did on expiration.
Long Put Trade Results
Trade Details at Expiration:
Stock Price: $170 –> $166
Strike Price: $165
Option Value: $2.25 –> $0
So we were right – AAPL fell after earnings. When we bought the put, the stock was trading at $170. It fell by $4 to $166.
But we own the $165 put – this strike price is out-of-the-money on expiration.
Remember, a put option gives you the right to sell stock. Why would you exercise that right to sell stock at $165 when you can sell stock in the market for a better price of $166. Nobody would do this – therefore, on expiration, nobody is willing to buy our put. Its value is zero.
As expiration approaches and the stock price stays the same or mildly fluctuates, options lose value. This is because of the option Greek “theta”, or time decay.
Take a look at the below image, which shows how the premium on a LEAP option (long-term option) compares to that of a near-term option of the same strike price.
So why does the premium dwindle?
Intrinsic and Extrinsic Value in Options Trading
The value of all options is composed of intrinsic and/or extrinsic values.
Intrinsic value is simply the amount an option is in-the-money by. If a stock is trading at $170, and you own a $175 put, the option is in-the-money by $5 – this is its intrinsic value.
Extrinsic value is all value that is not intrinsic value. Implied volatility and time value account for this value.
As time passes, out-of-the-money options lose value. Extrinsic value is what could happen. Earlier, we bought the $165 put on AAPL. If an hour before expiration, AAPL is trading at $170, what are the odds of the stock drpping by $5 in this short amount of time? Slim to none. Therefore, it will not have any “hope”, or extrinsic value during this time.
It is because of this profound time-decay most out-of-the-money options lose value. This is also why most professional traders SELL options.
Short Put Explained
Short Put Definition: The owners of long “American Style” put options can exercise their right to sell stock at any time. When this happens, the short party must be prepared to deliver 100 shares of stock.
You can both buy and sell options. Options sellers are at the mercy of the buyers – at any time, for American options, the owner of an option can exercise their contract. What happens to short puts here?
They must deliver 100 shares of short stock. This leaves the short put party long 100 shares of the underlying. However, options assignment rarely happens.
So, what exactly is a short put? It’s the exact opposite of a long put.
Short put sellers have market conviction the exact opposite of put buyers. They believe the underlying will either go up or stay the same in value.
Remember those detrimental effects of time decay? Well, for short options, time decay works in their favor.
Let’s take the other side of our above trade, and sell that option now.
Short Put Option Example
| Put Strike Price | Premium |
|---|---|
|
$170 |
$4.25 |
|
$165 |
$2.25 |
|
$160 |
$1.40 |
So in this example, we are going to sell that $165 put instead of buying it.
Trade Details:
Stock Price: $170
Strike Price: $165
Credit Received: $2.25 ($225)
When you sell an option, you receive a credit to your account (as seen above). However, this is not a free trade. Quite the opposite.
When you buy an option, the most you can lose is the debit paid. When you sell an option, that maximum loss scenario increases significantly. It is because of this your broker will require a lot of money held on the side to hold your short position. The cost of margin to sell our above put is over $1k! If the trade moves against us, our broker want to make sure we can cover the losses.
Short Put Maximum Loss: Strike Price Minus Premium Received
So for us, the max loss on this option is $162.75 ($165-$2.25), or $16,275! Remember this number is also the max profit on a long put – this should make sense.
When will this occur? If the stock is trading at $0 on expiration. Unlikely.
How much can we make?
Short Put Option Maximum Profit: Credit Received
Since we received a credit of $2,25, this is the most we can make on selling our put.
Short Put Trade Results
Trade Details at Expiration:
Stock Price: $170 –> $164
Strike Price: $165
Option Price: $2.25 ($225) –> $1 ($100)
So in this scenario, AAPL fell below our short put strike of $165 to $164. At the moment of expiration, our put was valued at $1.
Remembering that we sold this but for $2.25, we can see we made a profit of $1.25 ( (2.25-1).
Why was the put trading at $1 on expiration? Because when an option expires, all extrinsic value is gone. What remains is intrinsic value, which is synonymous with “moneyness”. Our option was in-the-money by $1.
Final Word
Put buying is generally a low probability, high reward trade. Put selling, however, is a high probability, low reward trade.
Over the long-run, selling puts generally makes more money than buying them. But, as stated by optionseducation.org, selling options has great risks. If you’d like to learn more about selling put options for income, please check out our article below!
