What is a long put?
A long put strategy involves buying a put option, giving the holder the right (but not the obligation) to sell the underlying asset at a specified price (strike price) within a specified period (until expiration).
The objective is to profit from a significant decline in the price of the underlying asset while limiting risk to the premium paid for the option.
Risk/Reward:
- Risk: Limited to the premium paid for the put option. The maximum loss occurs if the option expires worthless.
- Reward: The potential profit is capped at the strike price minus the premium paid, as the underlying asset's price cannot fall below zero. The breakeven point is the strike price minus the premium paid.
Example:
XYZ stock is trading at $50 and you expect the price to decrease over the next month. You buy the XYZ $45 put option expiring in 30 days for $2.50:
- The theoretical max gain is $45 per share, or $4,500 total for each contract bought, if XYZ stock price drops to zero.
- The theoretical max loss is $2.50 per share, or $250 total for each contract bought. Max loss occurs if XYZ closes at or above $45 on expiration, and the option expires worthless.
- The breakeven point at expiration is $42.50. It’s calculated by taking the strike price $45 and subtracting the premium paid ($2.50)
How should I manage a long put position?
A long put benefits when the stock price drops significantly, ideally falling below the strike price. Additionally, an increase in implied volatility generally boosts the option's value, assuming other factors remain stable. Conversely, if the stock price rises, implied volatility drops, and time elapses, the put's value typically decreases, which is unfavorable.
Although you have the right to exercise your option, it isn't the typical way to close a long put. Instead, you might consider selling your put before expiration to avoid the exercise process and any additional risk that it may introduce. There are different strategies to close a long put, you can sell the put option before expiration, roll it to a new expiration date or strike price, or hold it through expiration. The choice depends on the asset's performance and your expectations.
What should I do if my long put is expiring soon?
As expiration approaches, typically around 30-45 days out, the rate of time decay accelerates. The closer the option gets to expiration, the more its extrinsic value diminishes each day. Ultimately, at expiration, a put option is valued solely based on its intrinsic worth (the difference between the strike price and the stock price).
If your long put is profitable, consider selling it before expiration to lock in gains and avoid losing extrinsic value. If the option is out-of-the-money, you can choose to sell it to limit losses or let it expire worthless.
What can happen if I hold the long put at expiration?
When holding your contract until expiry, the following three scenarios can occur:
- It can either expire worthless out of the money, and you lose the premium you paid for it.
- It can get auto-exercised at expiry if you have the selling power to sell the underlying shares of the options contracts.
- It can auto-liquidate. If you don't have the selling power to exercise the contract, your broker will attempt to sell your option contract for its intrinsic value prior to its expiry.