2.4.1.7 Long puts
This chapter covers the fundamentals of long put options contracts. To gain a good understanding of the language used when discussing options, watch this video:
When an investor goes long a put, they are bearish on the underlying security’s market price. Purchasing a put provides the right to sell stock at the strike price. If the stock’s market price falls below the put’s strike price, the holder can potentially make a profit (“put down” - the put is “in the money”). If the market price rises above the strike price, the holder will not exercise the option and realizes a loss equal to the premium (the put is “out of the money”).
Let’s work through a few examples to understand long puts better:
Long 1 ABC Sep 75 put @ $6
This contract provides the right to sell ABC stock at $75 per share. The option costs $600 and expires on the third Friday in September. The investor is betting ABC stock’s market price falls below $75 before expiration. Otherwise, the option will expire, resulting in the investor paying $600 for a contract they never used.
Math-based options questions should be expected on the exam. Normally, they involve potential gains, losses, and breakeven values. Let’s go through each.
The maximum gain for a long put is obtained if the market price falls to zero. Let’s see what that looks like:
An investor goes long 1 ABC Sep 75 put @ $6. The market price falls to $0. What is the gain or loss?
Can you figure it out?
Answer = $6,900 gain
| Action | Result |
|---|---|
| Buy put | -$600 |
| Buy shares | -$0 |
| Exercise - sell shares | +$7,500 |
| Total | +$6,900 |
At $0, the option is $75 “in the money.” Stock going to zero is uncommon, but it happens. To realize their maximum gain, the investor first goes to the market and obtains 100 ABC shares for $0 (the stock is worthless). Next, they exercise the option contract and sell 100 ABC shares for $75. The exercise provides a profit of $7,500 ($75 gain per share x 100 shares). When the $600 premium paid upfront is factored in, the overall gain is reduced to $6,900.
A long put’s maximum gain can be calculated with this formula:
The strike price of $75 minus the premium of $6 leaves us with a maximum gain of $69 per share (or $6,900 overall).
Let’s look at an example that would be more likely to occur:
An investor goes long 1 ABC Sep 75 put @ $6. The market price falls to $60. What is the gain or loss?
Answer = $900 gain
| Action | Result |
|---|---|
| Buy put | -$600 |
| Buy shares | -$6,000 |
| Exercise - sell shares | +$7,500 |
| Total | +$900 |
At $60, the option is $15 “in the money.” The investor first goes to the market and purchases 100 ABC shares for $60. Next, they exercise the put and sell the shares at $75, locking in a $1,500 profit ($15 gain x 100 shares). When the $600 premium paid upfront is factored in, the overall gain is reduced to $900.
Put holders don’t always make a profit. Even if ABC’s market price falls below $75, the holder must make their premium back to realize an overall gain.
Let’s look at another example:
An investor goes long 1 ABC Sep 75 put @ $6. The market price falls to $69. What is the gain or loss?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Buy put | -$600 |
| Buy shares | -$6,900 |
| Exercise - sell shares | +$7,500 |
| Total | $0 |
At $69, the option is $6 “in the money.” The option gained intrinsic value, but didn’t make a big enough return on the exercise to profit overall. The investor buys 100 ABC shares at $69 in the market, then exercises the put and sells those shares at $75. This results in a $600 gain ($6 gain x 100 shares). When the $600 premium paid upfront is factored in, the investor has no profit or loss (breakeven).
When investing in puts, the breakeven can be found using this formula:
With a strike price of $75 and a premium of $6, the investor breaks even when ABC stock is at $69 per share. At this market value, there is no profit or loss.
The investor could be stuck with a loss if ABC’s market price doesn’t fall far past $75. For example:
An investor goes long 1 ABC Sep 75 put @ $6. The market price falls to $74. What is the gain or loss?
Answer = $500 loss
| Action | Result |
|---|---|
| Buy put | -$600 |
| Buy shares | -$7,400 |
| Exercise - sell shares | +$7,500 |
| Total | -$500 |
At $74, the option is $1 “in the money.” Although the option gained intrinsic value, it wasn’t enough to offset the premium. The investor buys 100 ABC shares at $74 in the market, then exercises the put and sells those shares at $75. This results in a $100 gain ($1 gain x 100 shares). When the $600 premium paid upfront is factored in, the investor is left with a $500 overall loss.
Expiration is the worst-case scenario for investors holding long options. When this occurs, the investor pays a premium for an option that is never used. The same applies to long put contracts.
An investor goes long 1 ABC Sep 75 put @ $6. The market price rises to $84. What is the gain or loss?
Answer = $600 loss
| Action | Result |
|---|---|
| Buy put | -$600 |
| Total | -$600 |
At $84, the option is $9 “out of the money” and has no intrinsic value. When the market price is above $75, there is no point in exercising the option. Why would the investor exercise and sell stock for $75 when the market is trading the stock for $84? Therefore, the investor lets the contract expire and realizes the loss of the premium (their maximum potential loss).
Long options can only lose the amount spent on the premium. If exercise will result in a loss, the investor will let the option expire.
Investors can also perform closing transactions to close their options before expiration.
An investor goes long 1 ABC Sep 75 put @ $6. After ABC’s market price rises to $79, the premium falls to $2, and the investor performs a closing sale. What is the gain or loss?
Answer = $400 loss
| Action | Result |
|---|---|
| Buy put | -$600 |
| Close put | +$200 |
| Total | -$400 |
The market price increased, causing the option premium to fall. Remember, premiums are not fixed and constantly fluctuate like stock prices. The premium was $6 when the put was originally purchased. Later, the premium fell to $2, the price achieved when the put was liquidated (closing sale).
The investor bought the put for a premium of $6 and sold it at a premium of $2, resulting in a $4 per share loss. With option premiums representing 100 shares, the investor realizes a $400 overall loss. To find the profit or loss for closing transactions, compare the price paid for the option to the price sold.
Here’s a visual summarizing the important aspects of long puts:
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