The long put option strategy is a nice alternative to shorting a stock. However, there are some things to be aware of because it is NOT the same as shorting a stock. As with the long call strategy, there are actually a couple of ways I like to trade.
The long put strategy is one to use when quite bearish on a particular stock, ETF or index. If I'm not that bearish or am uncertain as to the timeframe or magnitude of the move, I'd prefer a different strategy like the short vertical call spread.
I think I prefer a long put to a long call simply because when a stock is moving down, volatility is increasing, which adds to the rise in option price. Therefore, I can make money easier on the downside.
Since the long put is a bearish strategy, I want to make sure I'm picking a stock that is in a bearish trend already, or has recently changed from a bullish to neutral trend to a bearish trend. Sometimes the larger moves happen when the trend fails and the stock breaks a level of support that has held in the past.
For this discussion, I will use Caterpillar (CAT), which has
been a a
downtrend for the last few months.
Looking back at that last move we see that CAT moved from around $30 up to almost $34 before moving back down and ultimately breaking through. With this in mind, then a projected move might be around $4 or down to about $26.
With a long put, a really good entry is when a down trending stock breaks a level of support... especially one that has held in the past. Other good entries are catching a bounce down from a point of resistance.
I try to avoid any earnings announcements as they tend to have unpredictable results.
As I mentioned in the long call strategy, the two ways I trade the long put are an in-the-money (ITM) approach and an out-of-the-money (OTM) approach. Let's take a look at each one in turn.
With the OTM strategy, I'll want to look at a long put option that is several strikes OTM. It will have no intrinsic value and very little time value. However, if a large move is made, I will make a lot of money on it.
I often use this strategy as an inexpensive insurance policy. By that I mean that I may be holding shares of CAT and I want to protect it from a downturn... or I may be long in some way on an index or ETF and I want to protect myself from a downturn. The gains I make here offset some of the losses I may incur in the long stock, ETF or index position.
For this example, I also want to chose a timeframe that allows the move to develop (4-6 weeks). I'm going to choose the March $25 put, currently trading for $.78. For this option to break even on expiration day, CAT will need to be trading at $24.22 ($25-.78). However, I may be able to realize a nice profit if CAT moves quickly within the next few weeks.
The CAT $25 put currently has a delta of about -.22 so a move down of $4 would be approximately $.88, which is more than twice the original cost of the option.
The risk of this trade is that CAT may go nowhere or even bounce back above the broken support and your option value would melt away to nothing.
For this strategy, I like to choose an option that is several strikes ITM and has a delta of around .75-.90. The March option chain currently offers strikes in $1 increments above $30 so I can actually pick the $33 put with a delta of $.82. This option trades for about $5.05.
The advantage of the ITM options, especially this many strikes ITM is that the time value is a smaller percentage of the overall option price so I am less affected by time if nothing happens. For example, this strike has about $.33 of time premium. If CAT goes nowhere for 4 weeks, I still can keep $4.72.
This strike also has a delta of -.82 so the same $4 move down would yield an approximate $3.28 increase... that's a 64% return on your original $5.05 investment.
Before placing the trade, I will determine risk and projected reward. I've already more or less done that for each of the trades. Notice as I talked about projected gains & losses I had an approximate target move of $4 in mind for realizing maximum profit.
What about the worst case scenario? One possible outcome is that CAT goes absolutely nowhere. In this case, the OTM option will be worthless by expiration and the ITM option will retain about 90% of its value.
The other possible outcome is that CAT could rally and move back above
the broken support level. I have two possible ways to exit.
I could exit the position on a significant break of that
resistance level (maybe by 3%).
An alternative might be to exit when the long put option loses more than 30% of its value... although I'd probably be willing to allow the OTM to go to $0 since it didn't cost much to begin with.
With the OTM option, the projected reward is $.88 for a risk of $.78, a reward/risk of 1.1:1 (approximately 1:1)
With the ITM option, the projected reward is $3.28 with a risk of $1.51 (30% of the original $5.05 option cost). That's a reward/risk of 2:1.
For a strategy like this, a 2:1 reward/risk is a good objective.
Next, I'll determine how many contracts to purchase for each approach based on a total risk in this trade of $1000.Knowing that 1 option contract controls 100 shares, the calculation for each would be:
Some online brokers designate the opening order for a long put differently than closing orders. I may have to place the order as 'buy to open' 12 contracts of the March 25 put for an offer price of $.78. Later, I would close the position by issuing a 'sell to close' x contracts of the March 25 put for an ask price of $x.
When planning my exits for a long put, I think about three key areas, several of which I've already touched on.
I've learned the hard way that the best way to consistent profits is to have a process I follow consistently.
With the long put strategy, it is possible to make money from a strong bearish move of a stock. Because of the leverage options offer, I can realize a better gain from an options trade than shorting the stock. However, leverage goes both ways. Time is against me with a long put.
As I've discussed the various steps to trading the long put, I've followed a fairly structured approach (selecting the right stock, timing the entry, selecting the right options, entry, exit, etc). These are based on a set of trading rules I follow, which are part of an overall option trading system I follow. This is a critical aspect of successful options trading. I've found I can't be successful trading any strategy just by knowing the mechanics. Having a system that defines what I do every time I trade is what helps me be consistent in my profits.
|Outlook:||Near term to medium term bearish|
|Max Loss:||Cost of the option (but you can limit with a stop loss)|
|Time decay effect:||Works against you|