The long put and short put are option strategies that simply mean to buy or sell a put option.
If an investor wants to profit from an increase or decrease in a stock’s price, then buying or selling a put option is a great way to do that. This article will prepare investors to effectively use the long put and short put strategies to generate a profit.
A put option is a contract between a buyer, who is known as the option holder, and a seller, who is known as the option writer. This contract gives the holder the right, but not the obligation, to sell shares of an underlying security at a set price. The set price in an option contract is known as the strike price.
Put option contracts have expiration dates. Option contracts must be exercised before or on the expiration date, or the option will expire as worthless.
If an investor were to execute the long put strategy, then he would buy a put option and assume the role of the option holder. A long put strategy would be used if an investor expected the stock’s price to decrease.
If an investor were to execute the short put strategy, then he would sell a put option and assume the role of the option writer. A short put strategy would be used if an investor expected the stock’s price to increase.
Let’s look at examples of the long put and short put strategies.
- Long Put Strategy: Assume stock XYZ has a price per share of $100. An investor buys one call option for XYZ with a strike price of $95 expiring in one month. He expects the stock price to fall below $95 in the next month.
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As the holder of the option, he has the right to sell 100 shares of XYZ at a price of $95 until the expiration date. One option contract is equal to 100 shares of the underlying stock.
Let’s assume the premium for the put option costs $3 per share. Therefore, the holder pays $300 for the put option to the option writer. This amount is the maximum amount the holder can lose.
Assume the price of XYZ falls to $90 in that month. Now, the holder can exercise the put option and sell 100 shares of stock at $95, rather than $90. The holder can buy the shares of stock at the market price of $90, then immediately sell the shares at $95. This generates a profit of $5 per share for the holder.
However, if the share price never falls below the strike price of $95, then the put option expires, and the holder is at a loss of $300 because of the premium.
- Short Put Strategy: Assume stock XYZ has a price per share of $100. An investor sells one put option with a strike price of $98 that expires in a month. The investor expects the price of XYZ to increase within the next month.
For writing the put option, the investor receives a premium of $3 per share, or a total of $300.
Assume that within the month, stock XYZ never closes below $98. The option expires as worthless. The option writer profits $300 because of the premium.
However, let’s assume the share price did fall to $95 within the month. In this case, the option would have been exercised and the option writer would be obligated to buy the shares of stock at $98 rather than $95. That comes out to be a loss of $3 per share for the option writer.
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The long put and short put strategies can be used when an investor expects the price of an underlying stock to either increase or decrease. After reading this article, investors should feel prepared to generate a profit from buying and selling put options.