The long put and short put are two options strategies that refer to the purchase and sale of a put option.
If an investor wishes to benefit from a rise or drop in the price of a stock, then purchasing or selling a put is an excellent method to do this.
This essay will assist you in understanding how to profitably employ these alternatives to increase your chances of success.
What are Put Options?
A put option is a financial contract that entitles the buyer to sell an underlying asset (such as a stock, futures contract, or currency) at a specified price at any time until the contract expires.
Traders may buy-to-open or sell to open a put option.
A buy-to-open put is referred to as a long put. Additionally, a put that is to open is referred to as a short put.
As a buyer of a put option contract, i.e., a long put, you always have the right, but never the responsibility, to sell the appropriate amount of the underlying asset if the put option is in the money.
As a result, a seller of a put option contract, also known as a short put, is always required to sell the necessary amount of the underlying asset if the short put option is in the money.
How does a Put Option Work?
When studying how put options operate, there are many critical components to consider:
Writer and holder: Two parties are involved in put option contracts: the writer and the holder. The writer (also known as the seller) sells the contract to the holder for a one-time amount known as the option premium. The contract requires the writer to acquire shares in the underlying asset from the holder (a.k.a. the buyer) at an agreed-upon price within a certain time period—if the holder decides to sell. The striking price is the set price. Even if the buyer does not exercise his or her option to sell prior to the contract's expiration date, the contract writer retains the option premium money. The price of a put option varies according to the strike price, the underlying asset's cost, interest rates, market volatility, and time decay.
Short position: When an investor purchases a put option, they are wagering that the underlying asset's price will be lower than the strike price at the expiration of the put option contract. Given that the value of a put option grows as the underlying asset's price decreases, the buyer is effectively shorting the asset—though put options are not synonymous with short selling.
Time value: Time value is another significant component that affects the option's price. A put option is more valuable as the expiration date is extended since the profit potential on the investment is increased. As the expiration date approaches, the put option's value depreciates due to time decay. Once the expiration date approaches, the put option loses its time value and is reduced to its intrinsic value—the difference between the strike and current market prices. If the option's intrinsic value is positive, the buyer will often exercise their option to sell to profit.
How Does a Put Option Make Money?
The best options trading methods are popular only for their profitability. Let's go more into how trading methods using put options generate profits.
The premium reflects the option's intrinsic or temporal value. Consider a put option with a strike price of $10 and the underlying stock trading at $9. Then there's the inherent worth of one dollar.
Put options enable traders to profit from a decline in the price of a stock.
However, the option might trade at $0.20. That extra $0.20 represents time value since the underlying stock's price might very well move before the expiration date. Put spreads are created by combining several options on the same underlying asset.
How do Traders Use Put Options?
Traders generally use put options for speculation, hedging, and cost-basis reduction.
Speculation is the act of purchasing puts with the expectation that the underlying asset's value will decline before expiration. This is a high-risk transaction because if the underlying asset (such as a stock or futures contract) does not decline in value before expiration, the acquired put options will expire worthlessly. Similarly, traders might sell a put option to expect the underlying asset to not decline in value before expiration, rendering the put option worthless. The premium earned by option sellers is profit for the vendor.
Hedging: It is also usual practice to buy put options as a hedge against the underlying asset's probable decline. This is a very frequent strategy for long-term investors to hedge their investments. Purchasing stock and purchasing a put is equivalent to selling stock and purchasing a call.
Reduced Cost Basis: Covered puts are a popular strategy for traders who are short a stock to employ put options and lower their total cost basis. For example, if a trader is short 100 shares of XYZ at $50, he may sell one out-of-the-money put option at any strike price contract against his current short shares. If he sells a $45 put option for $0.80, he will retain the whole $80 premium unless XYZ is less than $44.20 at expiration. If XYZ is less than $44.20 at expiration, the transaction will still provide a $580 profit. Whatever happens, the trader retains the $80 put option premium.
What Is a Long Put?
A long put is when you purchase a put option, often in expectation of the underlying asset declines. The word "long" here does not relate to the time remaining before expiration but rather to the trader's activity of purchasing the option with the expectation of selling it at a better price at a later date.
A trader may purchase a put option speculatively, wagering that the underlying asset would decline in value, hence increasing the value of the long put option. Additionally, who may utilize a long put to hedge a long position in the underlying asset. If the underlying asset declines in value, the put option grows in value, partially compensating for the underlying loss.
Understanding a Long Put
The striking price of a long put is the price at which the put buyer has the right to sell the underlying asset. Assume that the underlying asset is stock and that the option's strike price is $50. This implies that the put option permits the trader to sell the stock at $50 regardless of whether the stock falls to $20. On the other hand, if the stock continues to grow and stays over $50, the option becomes worthless since it is pointless to sell at $50 when the stock is trading at $60 and maybe sold then (without the use of an option).
If a trader decides to execute his or her right to sell the underlying at the strike price, the option is exercised. Exercise is not necessary, and rather than that, the trader might simply sell the option before expiration.
Assuming it is an American option, who may execute a long put option prior to expiration, but who may only exercise European options on the expiration date. If the option is executed before expiration or if it expires in the money, the holder of the option would short the underlying asset.
What is a Short Put?
A short put strategy, also known as a naked put, anticipates a growth in the underlying stock's price or that it will remain unchanged at the strike price — this is a more bullish approach than a long put.
As with a short call, the primary objective of a short put is to increase the price of the stock's premium. A short put is a technique that involves selling a put option - preferably one that is farther out of the money if you are following a more cautious plan.
The danger associated with this method is that losses are not limited and may be significant. Given that you are selling a put option, you are obligated to buy a nearly worthless stock if the put expires at zero or shuts.
If you choose to sell options, you are compelled to buy or sell them, rather than just having the choice to buy or sell. As a result, selling put options on individual equities is riskier than selling ETFs, commodities, or indexes.
For short puts, sellers want the stock's price to exceed the strike price (making it worthless to the buyer) - at which point you will successfully collect the premium.
However, they vary from purchasing options in that the more the volatility, the worse the method performs. While time decay is often a disadvantage for options strategies, this method benefits from it since the objective is to generate a worthless contract.
How does a short put work?
When you short a put, you assume the duty to buy shares at the put option's strike price for a certain length of time.
This may happen if the stock price falls below the put strike price either before or at the contract's expiration. While this is consistent with the objective of purchasing the stock if it drops to a target price, there is a significant risk associated with purchasing the stock at the strike price when the market price is likely to be lower, and the price of the stock may continue to decrease. If the stock does not fall below the contract's put strike price, the contract will almost certainly expire worthless, and the put seller retains the premium.
Options contracts are impacted in ways that stock traders may not be aware of. It is critical to keep these points in mind when trading short puts.
You are not obligated to retain the put option until the contract expires. At any moment before the contract's expiration or exercise, you may buy to close the short put position. A buy-to-close transaction would include you paying a premium to terminate your commitment (just as you had received a premium when you sold to open the put). Profit or loss on the transaction will be the difference between the premium you earned for selling the put to open and the premium you paid for buying it to close, minus commissions and fees.
If the stock falls below the put strike price, you are not assured to be allocated the put. In other words, you are not obligated to buy the stock immediately if the market price falls below the strike price. Long put holders normally execute contracts on or around the expiration date; however, early assignment is possible. This is a significant distinction from a stock's limit buy order. Prior to the contract's expiration, the stock might fall below the strike price and then recover above it, and who may not assign the contract. This would result in you having no long stock position. In such an instance, you must first buy the put to close the position and then buy the underlying stock if you intend to buy the underlying securities prior to the option's expiration.
The put's price is influenced by variables other than the underlying stock's price, such as the time remaining before expiration and projected volatility. Option prices often decline as predicted volatility declines and increases when expected volatility increases. Additionally, the option price will tend to decline as the expiration date approaches. This is referred to as time decay, and it often increases as the expiration price approaches.
When is it Better to Trade Long Calls vs. Short Puts?
As you can see, both the long call and the short put have their advantages and disadvantages. Long calls have the advantage of lower risk and limitless profit potential. Short put has many advantages, including a positive initial cash flow and a lower break-even point (for the same strike).
Indeed, if the underlying stock moves significantly – to either side – the result of a long call is preferable to that of a short put. In contrast, a short put performs better if the stock does not move significantly (in our case, if it remains between $31 and $39).
This is a relatively regular occurrence when dealing with options. Generally, purchasing options (being "long volatility") are preferable when the underlying moves significantly. When the underlying asset does not move much, selling options (being "short volatility") are often preferable.
To summarize, while weighing the pros and cons of a potential long call or short put transaction, consider your expectations for the underlying stock price - not only in terms of direction but also in terms of volatility:
If you believe the stock will make a significant upward rise but do not want to lose too much money if it declines, go for a long call.
If you believe the stock will likely gain somewhat but will not fall significantly (it may as well move in a range for a time), go for a short put.
In reality, this becomes more difficult. The level of volatility presently priced into options will also influence your choice. If you anticipate range-bound trading, but the options market also does, and options premiums are low, selling a put may not be wise. This is a more difficult technique requiring a firm grasp of implied volatility and option pricing.
Both the short put and long put option strategies have an option-profit profile. However, the limited loss associated with a short put is far more than that associated with a long put.
When purchasing a put, the risk is always that the put premium would depreciate in value and expire worthless. The premium price is always equal to the highest potential loss on a long put.
In a nutshell, the underlying asset can technically devalue to zero. While this implies that the greatest loss is not limitless, it is serious. As a result, the maximum profit on a long put is rather considerable.
Conclusion
If an investor predicts a drop in the stock's price, he or she will use a long put strategy. If an investor chooses to use the short put method, he would sell a put option and assume the position of the option writer, as previously outlined. If an investor believes the stock's price will increase, he or she will use a short put strategy.
Frequently Asked Questions (FAQs)
What happens when a put option is exercised?
When you execute a put option, you will sell 100 shares to the put option seller (as the put option buyer). If you do not own the shares prior to executing the option, you will need purchasing power to fund the purchase—even if the shares are only held for a few minutes.
When is the best time to buy a put option?
In general, you want to buy a put option if you negatively affect a certain investment. In other words, buy puts if you feel the underlying stock's price will decline. Certain traders employ puts to hedge their other bets. For instance, if someone has a large amount of Apple stock, they may choose to buy an Apple put to ensure they do not lose everything if Apple goes bankrupt.
When a put option matures, what happens?
If a put option expires without being executed, it is effectively worthless. The brokerage firm will deduct the put option from the account of the individual who purchased it. The seller of the put no longer needs to worry about retaining the purchasing power necessary to acquire the shares. Bear in mind that brokerages may automatically execute options that are in the money (ITM) on the expiration date, which means that ITM options are unlikely to expire.
How is a put option closed?
If you sold the put to initiate the deal, you would close it by purchasing it at the current market price. If you purchased the put option initially, you would sell it to close the deal. The expiration or exercise of an option will also close at the conclusion of the deal for both parties.
Real-time News
