Long Puts
Risk: limited
Reward: very big
General Description
Entering a long put position simply entails buying put options…preferably ones that are in-the-money.
The Thinking
If you are very bearish a stock, you can short the stock or buy a put option which grants you the right to sell the stock at a predetermined fixed price. But what you gain in leverage you lose with time. Whereas a short stock position can theoretically be held indefinitely, options have an expiration date. So the stock doesn't just need to drop like you expect, it needs to do it within a specified period of time.
Example
Let's say CSCO is trading @ 16.07, and you think it will suffer a big drop in the next few weeks. You could short 1000 shares for $16,070, but instead you buy (10) 15 put options for $0.55 ($550) that expire next month
If the stock drops to 14.45, you will break even. For every point below 14.45, you will profit $1,000, so a huge collapse would bring you a huge profit (remember we said you get the benefit of being short without actually being short). If the stock closes above 15, the puts will expire worthless, and you will lose your entire investment. A closing price between 14.45 and 15.0 will get you some, but not all of your money back. Your max profit occurs if the stock drops to 0; your max loss is locked in place as your initial capital outlay.
The image below summarizes the trade with a P/L Diagram. |
