Long Put Strategy

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.

Outlook/Analysis

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.

Trade Entry


Selecting the right stock

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.

CAT long put example

CAT just broke down through a level of support at around $30. How far is the projected move? Some technical analysts will tell you that when a stock has moved between a high (resistance) level and a low (support) and then breaks one or the other, the projected move is equal to the range.

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.

Timing the entry

With a long put, a really good entry is when a down trending stock breaks CAT long put technical entrya 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.

Selecting the right options

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.

OTM strategy
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.

CAT ITM long put example

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.

ITM strategy
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.

CAT ITM long put example

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.

Analyzing risk/reward

Long Put P&L Graph

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.

Placing the order

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:

OTM: 1000/($.78 x 100) = 12.8 or 12 contracts. To purchase 12 contracts will cost $780.

ITM: $1000/($5.05 x 100) = 1.98 (we'll round up to 2 contracts). To purchase 2 contracts will cost $1010.

Now that I know which option and how many contracts, I can enter the order.

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.

Trade Exit

When planning my exits for a long put, I think about three key areas, several of which I've already touched on.

  • When will I get out if the trade goes as planned?
  • When will I get out if the trades goes against me?
  • How much time will I allow for the trade to develop?
If the trade goes as planned, when will I get out? I could either determine to close my option position if CAT reaches $26 or I could pick a target option price. Picking the target price of the option is a little trickier since there are a lot more variables that affect the price. However, using the stock price as my exit means I'm not exactly sure what I'll make until the trade closes.

Making sure I have an exit planned if CAT goes against me is almost more important than planning for the best case scenario. In the case of the OTM option, I've position sized for maximum loss of the option price so that one isn't as critical.

In the case of the ITM option, I've position sized for only a 30% loss. I always use a mechanical stop loss to guarantee I get out as planned.

If you don't have a mechanical stop set, you need to be available during trading hours to monitor AND be disciplined enough to exit or you will lose more than your 30%.

Don't try to be a hero or out think your exit plan. It will cost you!

Many online broker platforms allow a 'one cancels other' order such that I can place both orders simultaneously - one to get out with a profit and one to get out with a limited loss. With this kind of order, whichever order gets hit first, the other will be canceled.

I've learned the hard way that the best way to consistent profits is to have a process I follow consistently.

Summary

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 profit: Unlimited
Max Loss: Cost of the option (but you can limit with a stop loss)
Net Position: Long
Time decay effect:  Works against you



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