Playbook: Basis: the Long Put

Long Put

The long put is the opposite of the long call.

A put is an option to sell. The seller has the obligation to take the other side (sell the put). The buyer of the put option has a right to take delivery (put).

The position benefits from IV/IVR expansion, and/or the underlying price decreases below the strike (ITM).

Considerations

General

The reason for selecting this option strategy is that you expect the underlying to fall and be ‘In The Money’ (ITM): stock < put strike price). You make a better return than if you had bought the underlying itself.

These are the considerations for entering a short put:

• The expectation is that the underlying (stock, ETF, index, future) will fall: the outlook is bearish.
• The underlying has just experienced an increase.
• Implied Volatility (IV)/IVR (IV Rank) is low (<30), looking for options to increase in value over time.
• It’s difficult to sell (‘short’) premium as a leveraged alternative to selling/shorting the underlying.
• As downside protection of a bullish portfolio (‘hedge’).
• Risk is limited (‘defined’) to the premium paid (‘debit’).
• The maximum reward is ‘unlimited’ up to $0.00 price of the underlying.
• When you buy and therefore own an option, you are exposed to time (value) decay (‘hurts’), so typically, expiration dates should be reasonably far away (so >90 up to 180 DTE or even higher) to give you more time and a chance of the option increasing in value.

Owners of underlying shares who are bearish and looking to sell can buy a long put and choose the price to sell and the expiration of when to sell.

You can also consider LEAPS (trick if you think they’re expensive: divide the price by the number of months up to expiry and compare to shorter-term option prices).

Another method is buying ITM long put options. This increases the debit, but improves the breakeven.

Description

Set-Up

1. ‘ Buy to open’ (BTO) the put option ( in US 1 contract = 100 shares) at the put strike at which the underlying will be delivered if the right to purchase is exercised
   • 50Δ slightly ATM/ITM in less volatile underlyings
   • 30Δ OTM in more volatile underlyings

Related Options Strategies

The long put is one of the four basic options strategies on which all other strategies are built, especially options strategies with long put legs: vertical, calendar, and diagonal spreads, condors, butterflies, reverse straddles and strangles, etc.

The Greeks

Entry Rules

Profitable long puts require correctly selecting bearish underlyings AND good timing.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR below 30%.
• Ensure the trend is downward/bearish.
• Ensure at least three of the technical momentum indicators are positive.
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 50%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

Technical Indicators Used

1. Trend = bearish
2. Support & Resistance = the underlying has just experienced a pullback/decline to clear resistance level
3. RSI = overbought
4. Bollinger Bands in combination with Keltner Squeeze: at the top and outside the Keltner bands
5. ADX/DMI: increasing up and above 20
6. ATR low

P/L and Risk Profile

Net Position

Net debit, because you pay to buy the put option.

Theoretical Profit

As the stock price falls, the long put moves into profit more and more quickly, particularly when the stock price is lower than the strike price.

The reward is uncapped/unlimited when the underlying price < put strike to $0.00 underlying price: closing credit -/- debit

Theoretical Risk/Risk Profile

The maximum risk is the price you initially pay for the put (‘net debit/premium’) if the underlying price increases above the long put (even considerably).

If the underlying price increase to/above the long put: expires worthless.

Breakeven

Underlying put strike -/- net call premium/debit.

Managing AND CLOSING Position

Halfway to/Near Expiration

To better manage the position/mitigate losses: convert a profitable ITM long put position into a long put debit spread: sell an OTM put against the long put for a credit => (equal to or higher than) the initial cost of the long put.

Rules for Managing/Adjusting Position

• If the underlying decreases to the breakeven, the initial net premium/debit is covered (net even).
• If the underlying decreases below breakeven, the buyer will profit.
• If underlying increases (unprofitable): set two ATM puts for a credit and buy one ITM put for a debit (make sure credit covers debit costs), thus creating a long put spread.
• Set alerts on breakeven/predetermined target.

Rules for Closing Position/Exiting the Trade

• Profitable positions are closed by selling the option (STC) to close for a higher price than the net premium/debit paid to open the position.
• Sell the put option before the final month before expirations, so not later than 35 DTE.
• Manage multiple long puts by closing a portion of the position for profit, keeping some in place.

Mitigating a loss

• Work with a (mental) stop loss based on an underlying asset of either 50%, or 100% of the premium paid; if the underlying increases above the stop loss, exit by selling the puts.

Additional Notes

Advantages

• Profit from declining stock prices.
• Far greater leverage and cheaper than shorting stock (1 option represents 100 shares).
• The maximum loss of long put = debit and is capped; in the case of short-selling stock: the loss is the initial capital investment (and greater) + dividend payment (if applicable).
• Owners of underlying shares who are bearish and looking to sell can sell the shares outright (at the current market price) or buy a put and choose the price to sell and the expiration of when to sell.

Disadvantages

• Paying a net debit/premium.
• Possibility of 100% loss of the premium paid.
• No equity/margin value.