Risks and Rewards of a Long Put Strategy

By Stock Research Pro • October 19th, 2009

A Long Put is an options strategy used by investors looking to profit from a downward price move in an underlying security or an index. Under this strategy, the investor purchases a put option on the open market and then hopes for a price decrease of that security or index. For many investors, a long put presents a good way to take advantage of declining prices while assuming less risk than a short selling strategy would require. Purchasing a put generally has a lower up-front capital requirement than the margin a short position calls for.

About Put Options

A put option or a “put” is a contract between two parties, the seller or “writer” of the option and the buyer. Under the arrangement, the buyer assumes a short position and attains the right (but not an obligation) to sell the underlying security or index at a contracted price- the “strike price”. In acquiring this option, the buyer pays the writer a fee, known as an “option premium”. While equities represent the most widely-traded put options, many different types of securities and commodities are traded under put options.

Put Option: Risk v. Reward

The maximum profit the buyer of a put option can realize is limited by the fact that the underlying security can only decrease in value to zero. At contract expiration, an “in-the-money” put will be worth its intrinsic value only (the expiration of time eliminates any extrinsic value). The potential dollar loss for the buyer is limited to the premium paid for the put contract. The writer of the put takes on a potential loss that is limited to the strike price less the “spot price”- the current price of the underlying security.

Put Option as a Hedge Strategy

For investors with a bearish market outlook who are holding securities that they would prefer not to sell, a put option can provide a hedge against a market decline.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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