An investor pays a premium to buy, or go long, a put option. In exchange, the contract gives the owner the right to sell (or put), the underlying instrument (stock, ETF, futures, etc) at a specific level (strike price) through a set date (expiration month). As with call options, puts are quoted at bids and asks and prices are constantly changing along with the prices of the underlying. Changes in implied volatility and time decay also have important implications for options prices, which should not be overlooked. In the equity and index market, the multiplier for an options contract is 100. Therefore, to buy 10 puts that are trading for $2, the investor pays $2000 ($2X100X10).
A put option is in-the-money when the underlying is trading below the strike price of the options contract. The contract is at-the-money if the strike price and spot price are equal. An out-of-the-money put has strike price below the market price. Buying puts is a popular strategy to hedge a position in the underlying instrument. An often-used speculative strategy is to buy at OTM or ATM put, wait for the price decline in the underlying to fall and then offset (sell) the contract when it is in-the-money.
To illustrate the long put strategy, let’s make a bearish market bet on the SPDR 500 Trust (SPY). The so-called “Spiders” are down 10 cents to $138.50 heading into November. We expect rocky market conditions for the next few weeks. So we buy 5 January 136 puts on the fund for $3 per contract for a total premium purchase of $1500. Since SPY holds the same stocks as the S&P 500 Index, buying a downside puts on the fund allows us to participate if the market sees a substantial drop between now and the January 2013 expiration.
The risk to buying a downside put is that the debit is lost, if the position is left open through the expiration and shares hold above the $136 strike. At that point, the puts expire worthless because they are OTM and the premium paid is lost. The position can also be closed out for a profit or loss any time prior to the expiration by selling 5 SPY Jan 136 puts to close. If held through the expiration, the downside breakeven is at $133 and equals the strike price of the put minus the debit. At that point, the puts are worth $3, which covers the cost of the trade. There is substantial profit potential from a long put strategy, but the profits are limited due to the fact that the price of the underlying cannot fall below zero. If, for instance, SPY falls to $130, five Jan 136 puts are worth $6 at expiration, or $3,000, and the profit is $1,500. In other words, if the market drops 6.1 percent, the put position doubles in value.
LONG PUT EXAMPLE: BUY 5 SPY Jan 136 puts @ $3
Bias = Bearish on the underlying stock, ETF, index, futures
Breakeven = Put strike – put premium: 136 – $3 = $133
Risk = Limited to the amount paid for the put: $3 = $1500
Reward = Substantial, but limited to the underlying asset price falling to zero.