If you're familiar with options trading, you know that "long" typically denotes a position where a trader buys a contract, in this case, a put option. But what does it really mean to be "long" in the context of a put option, and how does this strategic move play out in the real world of trading? Keep reading to learn more.
Why miss out on the commodities market's potential?
Discover the untapped opportunities in top traded commodities CFDs like gold, silver & oil.
What is a Long Put?
A long put is a financial transaction that involves buying a put option — which gives the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame (before or on the predetermined expiry date).
In essence, the long put position is taken with the expectation that the price of the underlying asset will decrease significantly, allowing the trader to sell it for more than the market price.
Imagine you're at an auction, and there's an item you think might decrease in value soon. You buy a special ticket that gives you the right to sell this item at today's price within the next month, regardless of how much its price drops. If the price does drop as you predicted, you can buy the item cheaply and sell it for the higher price stated on your ticket. This difference, minus the cost of the ticket, is your profit.
In trading terms, the 'item' is a stock or another asset, the 'ticket' is the put option, and the 'price on the ticket' is known as the strike price. So, a 'Long Put' is when you buy a put option expecting the price of a stock (or another asset) to decrease. If it does, you get to sell it at the higher strike price and profit from the difference.
However, if the price doesn't drop, or increases, you won't exercise your right to sell, and the only money you lose is the cost of the put option (the ticket).
Remember, while this strategy can limit losses, it still involves risks and isn't suitable for everyone. Always consult with a financial advisor before diving into options trading.
How does a Long Put work in trading? (Example)
Suppose you believe that the price of Company XYZ, currently trading at $50 per share, is going to decrease in the next month. To capitalise on this prediction, you decide to buy a put option with a strike price of $45 that expires in one month. This put option gives you the right to sell 100 shares of Company XYZ at $45 per share until the expiration date.
If your prediction is correct and the price of Company XYZ drops to $40 per share, you have the ability to exercise your option, selling your shares at the $45 strike price. Since the market price is only $40, this means you've made a profit of $5 per share (minus the premium you paid for the option).
However, if the price of Company XYZ stays above $45, you might choose not to exercise your option. In this case, you would lose the premium you paid for the put option, but your losses are limited to this amount.
Remember, the key advantage of a long put is that it allows investors to limit their potential losses while benefiting from a potential decline in the price of the underlying asset.
Advantages and disadvantages of long put
Advantages
- Speculative gains: The long put position allows for potentially significant profits if the underlying asset's price drops substantially. This makes it a popular choice for speculative traders who believe that a stock is overvalued and its price is likely to decline.
- Hedging strategy: Traders could use a long put position as a hedge against a portfolio's long position. If the market takes a downturn, the put option could offset the losses incurred on the long position.
Disadvantages
- Timing is critical: The primary drawback of a long put is that timing is everything. Since the put option has a finite expiration date, the price of the underlying asset must fall before the option expires for the position to be profitable. If the market moves against the trader, the option could expire worthless, and the premium paid for it would be lost.
- Costly strategy: The payment of the premium for the put option represents the maximum potential loss. Thus, the strategy could be costly, especially if the trader is wrong about the market's direction.
Summary
Remember, while a long put can be a powerful tool for speculating on a price decrease or hedging against potential losses, it requires careful planning and proper risk management. Always consult with a financial advisor and do thorough research before getting started in options trading. Loved the post? Head over to the Skilling education center for more content on subjects like trading strategies for free.
Experience Skilling's award-winning platform
Try out any of Skilling’s trading platforms on the device of your choice across web, android or iOS.
FAQs
1. What is a long put in trading?
A long put refers to buying a put option, which gives the holder the right, but not the obligation, to sell the underlying asset at a specified price (the strike price) at or before a certain date (the expiration date).
2. When should I use a long put strategy?
A long put strategy is typically used when you expect the price of the underlying asset to decrease significantly. It allows you to profit from the decline in price while limiting your potential loss to the premium paid for the option.
3. What's the maximum profit and loss for a long put?
The maximum profit for a long put is theoretically unlimited until the stock price drops to zero. The maximum loss is limited to the premium paid to buy the put option.
4. How does time decay affect a long put?
Time decay, or theta, is detrimental to a long put position. As the expiration date approaches, the value of the option decreases if all other factors remain constant. This is because there is less time for the underlying asset to decrease in price.
5. Can I sell my long put option before it expires?
Yes, you can sell a long put option before its expiration date. This might be desirable if the option has increased in value due to a decrease in the price of the underlying asset.
6. What happens if my long put option expires out-of-the-money?
If your long put option expires out-of-the-money (i.e., the price of the underlying asset is above the strike price), it becomes worthless and you lose the premium paid for the option.
7. Is a long put a bullish or bearish strategy?
A long put is a bearish strategy because it profits from a decrease in the price of the underlying asset.
