Buying Puts

In the long put strategy, you are purchasing the right, but not the obligation, to sell the underlying stock at a specific price until the expiration date. This strategy is used when you anticipate a fall in the price of the underlying stock. A long put strategy offers unlimited profit potential with limited downside risk. It is often used to get high leverage on an underlying security that you expect to decrease in price. Let's create an example by going long 1 October Federal-Mogul Corp. (FMO) 65 put at 4 1/4. The Federal-Mogul Corporation's current market price is 63 3/8. This makes the 65 put an ATM option worth -50 deltas.

The risk graph for a long put trade slopes upward from right to left. This signifies that the profit increases as the market price of the underlying falls. This strategy offers unlimited profit potential and limited risk over the life of the option, regardless of the movement of the underlying asset.

The maximum risk of a long put strategy is limited to the price of the put premium. Therefore, this trade's maximum risk is limited to $425 (4 1/4 x 100 = $425) plus commissions. No matter how high the underlying asset rises, you can only lose $425. However, you have a limited profit potential to the downside as the underlying asset falls to zero. The breakeven for a long put strategy is calculated by subtracting the put option premium paid from the strike price of the put option. In this example, the breakeven would be at 60-1/4 (65 - 4-1/4 = 60-3/4). That means that as FMO falls below 60-3/4, the trade makes money. This strategy does not require a margin deposit.

To exit a long put strategy, you have the same three options as with a long call. You can let the option expire worthless, exercise your right to short the market, or sell a put option with the same strike price. Each alternative comes with its own set of advantages and disadvantages depending on how far the underlying stock moves and in which direction.

LONG PUT EXAMPLE SPECIFICS

Long 1 OCT FMO 65 Put @ 4 1/4
FMO @ 63 3/8
Net Debit: 4 1/4 or $425 (4 1/4 x 100 = $425)
Maximum Risk: $425 (4 1/4 x 100 = $425)
Maximum Profit: Limited to the downside as the underlying stock falls to zero.
Breakeven: 60 1/2 (65 - 4 1/2 = 60 1/2)
Margin: None