DESCRIPTION: A bearish strategy that allows an investor to benefit from the drop in the price of the underlying instrument to zero. This is the simplest of bearish trade structures an alternative to short-selling a stock. For someone who is long the underlying asset, buying a put is like buying price insurance on that asset. The initial cash outlay (debit) is similar to an insurance premium.
MOTIVATION: The investor who buys a put seeks to capture a profit from an fall in the price of the underlying asset. The advantage of this structure vis–à–vis short selling stock outright is that one can take a position with a much smaller capital outlay upfront (margin) while taking less downside risk. Consider the following example of a long (bearish) put spread.
OUTLOOK: The investor who buys a put is looking for a sharply lower price of the underlying asset to occur within a certain amount of time. Puts are appropriate when the investor has conviction behind an investment thesis, or they are looking for a particular catalyst to move the share price within a certain window of time. In addition, (married) puts are appropriate for price protection of an existing asset.
PROFIT/LOSS: Maximum (Strike – Asset Price, 0) – Premium Paid
The amount one earns at expiration is equal to the strike price less the price of the underlying asset or zero, less the initial premium paid, to buy the put spread.
MAXIMUM GAIN: Strike – Premium Paid
The maximum gain on a long put is only limited by the fact that the price of the underlying instrument can only go to zero. Therefore the maximum one can earn on a long put is equal to the strike price less the cost of the put.
MAXIMUM LOSS: Net Premium Paid
The maximum one can lose is the premium they pay up front to establish the position. This will happen if the stock sits at a price above the strike at expiration.
BREAKEVEN: Asset Price = Strike – Premium Paid
The investors will breakeven if the asset price at expiration is below the strike price of the option by an amount equal to the premium paid when the trade was initiated.
VOLATILITY: An increase in implied volatility would increase the profitability of a long put position. After price, implied volatility is the second most important factor in determining an options price.
TIME DECAY: The market value of a put will decline as time passes. Time decay increases as implied volatility increases and the time to expiration declines.
ASSIGNMENT RISK: None. The owner of an option decides if they want to exercise or not.
EXPIRATION RISK: Not very high. The only risk concerns the delivery of stock if the owner of the put wants to exercise their right. Either they have to own the stock for deliver, or their broker has to borrow stock and deliver on behalf of the investor.
STRATEGY PAIR: The profit/loss payoff profile for a long put is the same as that for a short stock and long call synthetic. Put-call parity suggests that stock plus a put is equal to cash plus a call. So a put is the same as holding a position that is short stock, long cash and long a call.