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Using Stock Downturns to Your Advantage With Long Puts
Unlike buying calls, where profits come from rising stock prices, buying a put is a strategy that is profitable when the price of a stock is falling. It can be compared to selling a stock short, but, like most option strategies, there are several ways you can use a put option.
How Does A Put Work?
A long put is an option contract that provides the owner of the contract the right, but not the obligation, to sell a specific security at a designated price within a set timeframe. A long put is the opposite of a long call, which gives the owner the right, but not the obligation, to buy a specific security at a designated price within a set time frame.
Long Put Example
We’re going to illustrate this by comparing shorting a stock, which entails borrowing shares of stock and selling them at the current price, to buying a put on it.
If you believe XYZ stock is set to decline over the next 30 days, you could short 100 shares of stock at its current price of $50 per share, or you could purchase a put with a $50 strike price that expires in 30 days at $1 per share. With the put, you would control 100 shares of stock.
To short a stock, there must be shares available to borrow. This is could be an issue for stocks that are not popular or widely held. Additionally you could be required to cover your short position if those shares are no longer available to be borrowed.
If you’re able to short 100 shares of XYZ, you would be required to maintain a certain amount of equity in the account. If the stock falls to $40 per share, your short stock position profit would be $1,000, or 20% ($1,000/$5,000).
If you buy one put contract, you’re required to pay $100 ($1 x 100). If the stock price drops to $40, your put position would also be worth $1,000 ($50 Strike - $40 Stock Price= $10 x 100 shares). This represents a 900% return ($1,000 - $100/$100).
Risk: A protective put strategy raises the breakeven on the underlying by the amount paid for by the put. If the underlying stays above the strike price you can lose the entire premium upon expiration.
Long Put Graph
In the graph shown here, the vertical (Y-axis) represents profit and loss, while the horizontal (X-axis) shows the price of the underlying stock. The blue line shows your potential profit or loss given the price of the underlying stock.
Why Would You Buy a Put?
- Buying puts limits your risk compared to selling short. If you sell short, you must borrow shares on margin. Furthermore, you face unlimited risk when you sell short, as the price of a stock can theoretically rise indefinitely. When you buy a put, you pay a premium to the seller. That premium is your maximum loss if the stock doesn’t fall below the strike price in a given time frame.
- Buying puts can help protect your assets or provide a profit in a bear market. If the price of the security drops below the strike price of the option, you may be able to sell your contract for more than you paid for it.
Alternatively, if you own shares of the same stock, you can exercise your put and sell your shares at the strike price for more than market value. Even if the price rises instead of declines, you can let the option expire and hold onto your shares. In that case, you would lose the premium you paid for the option.
Next Step: Learn more about option strategies in Scottrade’s Knowledge Center.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting www.888options.com). All option accounts require prior approval by Scottrade. Market volatility, volume, and system availability may impact account access and trade execution. Supporting documentation for any claims will be supplied upon request.
The information and content provided is for informational and/or educational purposes only. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
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