Summary: Like the long call, the long put is a simple option strategy to set up. With a put option you can have exposure to a decline in the price of the underlying asset
What is it and why would you want to buy this?
A purchased put option gives the right to sell an underlying asset (a share, for example) for a certain amount during a certain time. It can be seen as similar to an insurance policy on a stock or portfolio. You can also of course buy this right to sell if you think a share is going to fall, in which case you do not use it as an insurance policy, but as a way to profit from an (expected) decline in the price of a share.
Suppose you expect a certain stock to fall. You can now buy an option that gives you the right to sell the share for a certain amount. An option contract is valid for 100 shares, so prices will always have to be multiplied by 100. The right has a certain timeframe or term and this can vary from a few days to a few years. It’s important to note that an option with a longer term is more expensive than an option with a shorter term. After all, the chance that the share will move is greater the longer the term is. The term of normal options typically ends on the third Friday of the expiry month. The only exception to this are the daily and weekly options.
The other key detail you want to know in advance is the price at which you can sell the share. This is called the “strike price” of the option. The strike price of a put option determines the price at which the share may be sold. It should be clear that if you want to insure the share for a higher amount, you have to pay more for it!
Example:
Let's take a look at APPL stock. The share is currently trading around $145 and you are convinced that the share will fall. You are thinking of buying a put to take advantage of the expected decline.
You think that the stock will fall below $130 in the short term. You decide to buy the put AAPL 130 Put with a maturity of March next year and it will cost you $5.70.
What does this mean?
If you were to buy this put, you have the right – and not the obligation – to sell the Apple share at $130. This right runs until expiry date chosen.
When are you happy with this right?
If the expected decrease actually takes place to $110. You then have the right to sell the share for $130, while you could only sell it on the stock exchange for $130. This right is therefore worth at least $20 and that is 350% return on your investment
When are you not happy?
If the share does not fall, but remains the same or rises. The right to sell at $130 will then become worth a little less.
When do you buy a put?
One reason could be to protect your stock against a sharp drop. In this case, a put is a kind of insurance. A second reason may be the expectation that a share (that you do not own) will fall. You can then anticipate a decline in the share. It is then not a protection, but a way to take advantage of an expected decline
When will you sell the purchased put?
Once you've bought a put, you don't have to stay in it until the end of the term. You can also sell this put at any time during the trading day. So you could buy a put on Wednesday and sell it again on Friday.
You can decide in advance when you want to sell the put. When you take profits depends on your view of the underlying asset. If you think the underlying value may fall further, you don't have to say goodbye just yet. You can also choose a target, for example, a doubling the option price. Once this is achieved, you sell. It is also wise to determine in advance when you will sell in the event of a loss. For example, you could follow a rule that if you lose 50% of the value then you sell the option. You can also choose to lose the entire option premium because you know that the loss can never be greater than the premium paid.
What is your maximum risk?
If you do not own the shares, the maximum risk you run when buying the put is the premium you have paid. That is your maximum loss and will occur if the stock remains above the strike price you bought. But you can never lose more than the option premium you paid
In short
You can buy a put option without owning the shares. You do this if you expect a big drop. Choose the term and exercise price that suits your vision. Your maximum risk is known in advance and that is the price you paid for the put option.
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