Wednesday, August 29, 2012

Options 2.0 - Part 6. Basic Options Strategies; Long Put

The original column has been published in Dutch on August 28 at Telegraaf's / Goeroes / Opties 2.0 – deel 6. Basis Optiestrategie; Long Put

Basic options strategies
In my previous article of August 24th, "Basic Option Strategies", you read all about the 4 basic option strategies. And we covered the first strategy, the Long Call.
Today I’m going to talk about the second basic option strategy: the Long Put.

Long Put (Buying a Put option)
The Long Put consists of a single leg; Buying a Put option.

A Long Put becomes attractive when you expect a (significant) decrease in the price of the underlying asset. Upon expiration, this price decrease must compensate for the time value included in the Put option premium at the time of purchase.
A Long Put can also provide protection for your portfolio.

The investment amounts to the number of contracts that you purchase x the Put option price x the contract size. If you buy 4 Put options for 12.50 you pay 4 * 12.50 * 100 = 5,000 Euros.

The Long Put strategy has no margin obligation.

Break-Even Point
You’ll reach the break-even point upon expiration if the price of the underlying asset is equal to the strike price of the Put option minus the price that you paid for the Put option. The Put option now has only an intrinsic and no longer a time value. Which is why your result is 0.
So, to achieve the break-even point, there must always be a decrease in the price of underlying asset.

You’ll make a profit upon expiration if the price of the underlying asset is below the break-even point.

Maximum Profit
The maximum profit that can be achieved using a Long Put is equal to the strike price of the Put option minus the purchase price of the Put option. Upon expiration, the Put has a value equal to the strike price minus the price of the underlying asset. So the lower the price of the underlying asset, the more the Put option will be worth and the better your result.

You’ll make a loss upon expiration if the price of the underlying asset is above the break-even point.

Maximum Loss (Risk)
Your maximum loss is equal to your investment. If upon expiration, the price of the underlying asset is equal to or higher than the strike price of the Put option, the Put option will have no remaining intrinsic value. The Put option will expire at 0 and you’ll have lost your investment.

Price of the Underlying Asset (Delta) Influence
Negative. A Long Put has a negative Delta. A higher underlying asset price results in a lower Put option premium.

Remaining Maturity (Theta) Influence
Negative. Time works to your disadvantage with a Long Put strategy, because the remaining time value of the Put option reduces daily.

Volatility (Vega) Influence
Positive. A higher volatility indicates a greater remaining time value for the Put option and thus a higher Put option premium.

The advantage of the Long Put is that the potential profit is more or less unlimited.
But be careful. An unlimited gain might sound tempting. But there is also a downside. The chance that you’ll make a huge profit is extremely limited. Firstly, because the price of the underlying asset must usually decrease dramatically. And Secondly, because you’ll normally have already taken your profit at a much earlier stage.

The disadvantage is that if you want to achieve a profit with a Long Put, then the price of the underlying asset upon expiration must have at least decreased in line with the time value that is included in the Put Option purchase price at the time of investment.

Suppose that we buy a Put option on the AEX-Index with a strike price of 345.00 for a price of EUR 12.50. The AEX lists it at 335.77 at that moment in time.
One Put option requires an investment of 1 x 12.50 x 100 = EUR 1,250.
The Put option premium includes a time value of 1.23. Thus 12.50 – intrinsic (= 345.00 – 335.77) = 12.50 – 9.23 = 3.27. So the AEX price must decrease upon expiration by 3.27 (from 335.77 to 332.50 = -1%) in order to reach the break-even point. And if the price were to drop below 332.50 we would achieve a profit using this strategy.

Upon expiration the outcome would be as follows:

Long Put Graphical Simulation:
The x-axis shows the various price levels of the underlying asset.
The y-axis displays the (expected) result. The blue line indicates the expected result one month prior to expiration. The red line shows the result upon expiration.

The most common pitfall for private investors using Long Puts is to purchase “cheap”, short-term, out-of-the-money Put options, in the expectation (=hope) that the price of the underlying asset will drop sharply with time. The statistical probability of such a rate decrease before expiration is usually quite small. In fact, this type of option often expires at 0. Which results in a 100% loss. If the rate decreases, you must already have realised a substantial percentage gain, to be able to absorb the loss of the previous / following return. Please refer to the simplified calculation for Long Calls.

Options 2.0 ... Basic Options Strategy; Short Call
In this article we’ve taken a look at the second basic option strategy with a single leg; the Long Put. And we’ve covered how to use it and what the advantages and disadvantages are.
In the next article we’ll examine the third basic single leg options strategy; we’ll explore the Short Call.

Herbert Robijn is founder and director of FINODEX ( FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

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