Knowledge Base

What is a Long Put Strategy?

in Trading Strategies
Tags: Long Puttrading strategy

‘Buy at lows; sell at highs’ is the most basic ideology of stock market traders and investors. So, you buy a share today anticipating a higher value in the future. But what if you want to protect your profits from a fall in value in the future? You can use the long put strategy.

Here is all you need to know:

What is a long put strategy

A long put strategy is a ploy used by investors to profit from a fall in the price of a financial asset, such as a stock, index, currency or commodity. It involves fixing a price to sell the asset at in the future by buying (i.e. going long on) a Put Option on it. A Put Option is a contract that allows you to sell an asset at a fixed price on a future date. You have the right to sell, but not necessarily the obligation to actually fulfill the terms of the contract. In return for this, you pay a small compensation called premium.

Application of a long put strategy

A long put strategy is typically used by investors who are bearish on (i.e. pessimistic about the prospects of) an asset; they worry about a future fall in the asset’s value. By buying the Put Option, they fix a price to sell it at in the future if it depreciates. However, since the Put Option does not impose an obligation on him, he is free to not sell the asset if its value rises instead of depreciating.

Example of a long put strategy

Suppose a stock index is currently trading at 1,500 and is expected to fall in the future. To benefit from the fall, you could buy a Put Option on the index with a strike price of Rs 1,500, a contract multiplier (equivalent to number of shares) of 25 and a maturity of one month. This would allow you to sell the equivalent of 25 shares of the index at today’s price when it falls below it. For this, you will have to pay a premium of say Rs 3,000.

Payoff of a long put when the asset depreciates

Let us assume that the index depreciates to 1,200, as expected, after one month. By using the Option, you will be able to effectively sell it at the original value of 1,500 and make a profit of Rs 7,500 (Rs 300×25). Subtracting the premium you paid to buy the Option, your overall gain is Rs 4,500.

Payoff of a long put when the asset appreciates

However, suppose that the index appreciates to 1,800 after one month. You will now make a loss if you use the option. This is because you will basically end up selling an asset that is valued at Rs 1,800 for Rs 1,500. So, you will not exercise the option and only lose the premium of Rs 3000 that you paid to buy the Options contract.

Benefits of a Long put

A similar effect to a Long Put can be created using a strategy called Short Selling. This allows you to borrow and sell an asset now and buy it back later, when its price falls. This helps you earn the difference between the two prices.

The Long Put strategy is of greater benefit than short selling. This is because, in a short sell strategy, you are required to buy back the asset to close your position. This could lead to huge losses if the asset appreciates instead of depreciating, because then, you will have to pay more for the asset than what you sold it for.

In case of a Long Put strategy, you have an option. If the asset’s price moves adversely, you can choose against exercising the option and thus, prevent a loss. Moreover, short-selling requires you to buy and sell the asset at its full price. In a Long Put strategy, you are only required to pay a premium to buy the Option—a fraction of the asset’s price.