Options Trading - Long put strategy

A long put is an options strategy deployed by traders when they hold a bearish view on the underlying. In this strategy, a trader buys a put option contract and expects the underlying price to fall before the contract expiration.

What is a put option?

A put option holder has the right but not the obligation to sell a contract at a predetermined strike price on or before the expiry. Similarly, the put option seller has an obligation to buy the contract mentioned above at the predetermined strike price when the buyer of the put option chooses to exercise this option.

How to deploy a long put strategy

Let’s understand the long put strategy with the help of an example of SBI Cards.

Ms Smita, a trader, is bearish on SBI Cards, which is currently trading at ₹745 on 24 January. She believes that the stock will miss street estimates in its third quarter results to be announced on 24 January. Keeping a bearish view in mind, she buys a put option of 750 strike for the premium of ₹24 of February expiry. The lot size of SBI Cards in Futures and Options is 800 shares.

Break even point of the strategy

The breakeven point of an options strategy is the point where the strategy makes no profit or loss. In the case of the long put strategy, a trader can calculate the breakeven by subtracting the net premium paid from the selected strike price. For example:

Selected strike price: 750
Premium paid: ₹24
Break even point: ₹726 (750-24)

Selection of strike 📈

A trader can analyse and select the appropriate strikes from the option chain by evaluating the premium and its proximity to the breakeven point. With this, a trader can adjust the net premium paid to bring the breakeven point closer to the underlying. To understand this better, let’s analyse all three OTM, ATM and ITM strikes of SBI Cards.

SBI Cards spot @ ₹745

As you can see from-the table above:

1. The OTM strike of SBI Cards 740 put option with the lowest premium has the highest break even point. It means that the shares of SBI Cards have to tumble 3% (more than 24 points) from the current market price (CMP) at or before the expiry to cross the breakeven point.
2. The ATM strike of 750 put option with moderate premium has a breakeven point between the breakeven figures of OTM and ITM strikes. For the ATM strike to cross the breakeven point, the shares of SBI cards have to fall 2.6% (more than 19 points) at or before the expiry.
3. The ITM strike of 760 put option with the highest premium has a breakeven point closest to the underlying. It means that if a trader selects this strike, then the shares of SBI Cards have to decline by 1.7% (more than 13 points) to cross the breakeven point at or before the expiry.

Based on the expectation of the movement, a trader can select the strike which keeps the breakeven point closest to the current market price of the underlying. In the example above, we have chosen an ATM strike because the ITM options have a higher premium. In case the view of the trader goes wrong, the loss of the ITM option will be higher in comparison to the ATM strike.

Meanwhile, a trader can also sell a corresponding put option strike which can move the breakeven point closer to the current market price. This strategy is known as the Bear Put Spread.

Good to know

• If SBI Cards fails to make any move and closes at or above the strike price of 750 put option, then the trader will face a loss. The trader will lose the entire premium as the option will expire worthless.
• Consider deploying a long-put strategy when the stock or an index breaks the support or a consolidation zone towards the downside.

Maximum gain

In a long put strategy, the potential profit is limited but substantial. Since the value of a stock can decline and become zero, the maximum gain for the put option is capped at the value of the underlying. As you can see in the payoff graph below, once the shares of SBI Cards skid below the breakeven point, i.e. 726 (move of 2.6% from the current market price, ₹745 ), the profit potential for Ms. Smita becomes substantial.

Maximum loss

If the shares of SBI Cards stay at or above the 750 put option strike before the expiry, the strategy will make a loss. The maximum loss that Ms. Smita will incur in this strategy is the amount of premium paid, i.e. ₹19,200 (₹24* 800).

Advantages of deploying a long put strategy

• The long put strategy is a single-leg option strategy which makes it simple and easy for a trader to execute.
• Based on the view, once the strategy is deployed the profit for the strategy remains potentially unlimited.
• A gradual increase in implied volatility works in favour of the strategy. Meaning, if the implied volatility is expected to rise then the option price will gain the value, which will result in positive P&L for an option buyer.
• Since it is a net debit strategy, the risk of the trader remains limited. Meaning, if the price of the underlying rises and makes a sharp move against the view- the maximum loss will be capped to the net premium paid.

Disadvantages of deploying a long put

• Even though the risk in the long put strategy is limited, if the view goes wrong, the trader can lose the entire capital deployed. Hence, traders should follow strict risk-management practices and always trade the strategy with a stop loss.
• Similar to all long option strategies, the time value (Theta) works against the long put option strategy as well. The options contract with a longer time to expiration will have higher exposure to time value. So, before initiating a long option trade always keep in mind that the long options have negative theta and short options have positive theta value. This means, as time passes an option buyer will lose money due to erosion of time value and an option seller will gain money from erosion of time.
• A fall in implied volatility works against the option buyer. It means that once the implied volatility starts decreasing- the option premium starts losing the value and it starts working in favour of the option seller.

We hope this strategy was simple and easy to understand. You can try spotting it on the option chain on Upstox and see if you are able to identify levels.

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