Buying a Put Option – Part 1/2

The LONG PUT is one of the 4 basic option trading strategies and it has a bearish bias that creates an unlimited reward position with limited risk exposure.

Example:  Let’s say you are bearish on Apple (AAPL) and believe that it will drop to $175 by Jan 2010.  To take advantage of this move, you decide to purchase a PUT option.  With AAPL currently trading at ~$203, you analyze the option chain (calls on left and puts on right) and decide to purchase the Jan 185 put.  The option premium for the long put is $4.65 and your trading platform should automatically debit $465 from your account.

The LONG PUT option has the following characteristics similar to that of the long call:

• Maximum Reward/Profit = Unlimited
• Maximum Risk = Debit Paid to enter position

The unlimited reward potential is possible because AAPL can drop to $150 or even $0, but the put option gives you the right to sell it for $185/share, making the option worth a lot of $$.  ***This does not mean you have to sell AAPL stock; you can just sell the put option and take your profits.

On the other hand, if AAPL does not trade below the strike price of 185 by expiration, then the maximum you have lost is the debit you paid to enter the trade.  If you think that AAPL is not going to trade below $185 before expiration, then you can sell the put option and salvage any remaining value.  You do not have to let it expire worthless!!

Remember that at expiration, an option only contains intrinsic or “real” value, thus AAPL must close below $185 for the position to start making money.  I purposely said “start making money” because the position will only profit once you have recovered the option premium paid.  Therefore, the breakeven point for this position is $180.35 and AAPL will have to close below this point for you to turn a profit.

Breakeven = Strike Price – Option Premium (185-4.65=$180.35)

By buying a PUT option, you entered a bearish trade in AAPL that has an unlimited reward potential with limited risk for a fraction of the cost.

Continue reading “Buying a Put Option – Part 2/2” to look at the risk profile, a graph that shows Profit/Loss for the position at expiration.