The investor buys a put contract that is compatible with the expected timing and size of a downturn. Although a put usually doesn’t appreciate $1 for every $1 that the stock declines, the percentage gains can be significant. the put holder is willing to forfeit 100% of the premium paid and is convinced a decline is imminent, one choice is to wait until the last trading day. If the stock falls, the put might generate a nice profit after all. However, if a quick correction looks unlikely, it might make sense to sell the put while it still has some time value. A timely decision might recover part or even all of the investment.
The investor is looking for a sharp decline in the stock’s price during the life of the option.
This strategy is compatible with a variety of long-term forecasts for the underlying stock, from very bearish to neutral. However, if the investor is firmly bullish on the underlying stock in the long run, other strategy alternatives might be more suitable.
This strategy consists of buying puts as a means to profit if the stock price moves lower. It is a candidate for bearish investors who want to participate in an anticipated downturn, but without the risk and inconveniences of selling the stock short.
The time horizon is limited to the life of the option.
A put buyer has the opportunity to profit from a fall in the stock’s price, without risking an unlimited amount of capital, as a short stock seller does. What’s more, the leverage involved in a long put strategy can generate attractive percentage returns if the forecast is right.
Another common use for puts is hedging a long stock position. It is described separately under protective put.
These remarks are targeted toward the investor who buys puts as a standalone strategy. See the discussion on protective puts for a discussion on using long puts as a way to hedge or exit a long stock position.
The maximum loss is limited. The worst that can happen is for the stock price to be above the strike price at expiration with the put owner still holding the position. The put option expires worthless and the loss is the price paid for the put.
The profit potential is limited but substantial. The best that can happen is for the stock to become worthless. In that case, the investor can theoretically do one of two things: sell the put for its intrinsic value or exercise the put to sell the underlying stock at the strike price and simultaneously buy the equivalent amount of shares in the market at, theoretically, zero cost. The investor’s profit would be the difference between the strike price and zero, less the premium paid, commissions and fees.
The profit potential is significant, and the losses are limited to the premium paid.
Although a put option is unlikely to appreciate $1 for every $1 that the stock declines during most of the option’s life, the gains could be substantial if the stock falls sharply. Generally speaking, the earlier and more dramatic the drop in the stock’s value, the better for the long put strategy. Given that the premium investment can be small relative to the stock value it represents, the potential percentage gains and losses can be large, with the caveat that they must be realized by the time the option expires.
All other things being equal, an option typically loses time value premium with every passing day, and the rate of time value erosion tends to accelerate. That means the long put holder may not be able to re-sell the option at a profit unless at least one major pricing factor changes favorably. The most obvious would be an decline in the underlying stock’s price. A rise in volatility could also help significantly by boosting the put’s time value.
An option holder cannot lose more than the initial price paid for the option.
At expiration, the strategy breaks even if the stock price equals the strike price minus the cost of the option. Any stock price below that level produces a net profit. In other words:
Breakeven = strike – premium
An increase in implied volatility would have a positive impact on this strategy, all other things being equal. Volatility tends to boost the value of any long option strategy, because it indicates a greater mathematical probability that the stock will move enough to give the option intrinsic value (or add to its current intrinsic value) by expiration day.
By the same logic, a decline in volatility has a tendency to lower the long put strategy’s value, regardless of the overall stock price trend.
As with most long option strategies, the passage of time has a negative impact, all other things being equal. As time remaining until expiration disappears, the statistical chances of achieving further gains shrink. That tends to be reflected in eroding time premiums, which put downward pressure on the put’s market value.
Once time value disappears, all that remains is intrinsic value. For in-the-money options, that is the difference between the going stock price and the strike price. For at-the-money and out-of-the-money options, intrinsic value is zero.
None. The investor is in control.
Slight. If the option is in-the-money at expiration, it may be exercised on your behalf by your brokerage firm. Since this investor did not own the underlying stock, an unexpected exercise could require urgent measures to find the stock for delivery at settlement. A short stock position might be a problematic outcome for an individual investor.
Every investor carrying a long option position into expiration is urged to verify all related procedures with their brokerage firm: automatic exercise minimums, exercise notification deadlines, etc.
All option investors have reason to monitor the underlying stock and keep track of dividends. This applies to long put investors, too.
On an ex-dividend date, the amount of the dividend is deducted from the value of the underlying stock. Assuming nothing else has changed, a lower stock value typically boosts the put option’s value. The effect is foreseeable and usually gets factored more gradually, but dividend dates could nevertheless be one consideration in deciding when it might be optimal to close out the put position.
Exercising a put would result in the sale of the underlying stock. These comments focus on long puts as a standalone strategy, so exercising the option would result in a short stock position, something not all individuals would choose as a goal. The plan here is to resell the put at a profit before expiration. The investor is hoping for a dramatic downturn; the sooner, the better.
Timing is of the essence. Some put holders set price targets or re-evaluation dates; others ‘play it by ear.’ Either way, all value must be realized before the put expires. If the expected results have not materialized as expiration draws near, a careful investor is ready to re-evaluate.
Net Position (at expiration)
Long 1 XYZ 60 put
Strike price – premium paid
Source: www.optionseducation.org Read more
With most economic indicators suggesting that the Great Recession is coming to an end, it’s tempting for a business that has successfully weathered the storm to breathe a sigh of relief and look forward to business as usual. But experience tells us that complacency is the worst mistake a business — especially a startup — can make.
Just ask Digital Equipment Corporation (DEC), the precursor to Microsoft and Apple and creator of the minicomputer. By 1990, DEC was riding high, ranked only behind IBM in the computer industry. But under the leadership of Ken Olsen — who once famously derided the emerging personal computer, saying, “There is no reason for any individual to have a computer in his home” — DEC stuck with its original vision and its product lines, which were incompatible with emerging operating systems.
Related: Learning to Adapt Is the Key to Success
Olsen was removed from the board in 1995 and DEC was purchased by Compaq in 1998. By then, the company had lost money for five of its last seven years.
Complacent companies believe they have figured out the formula to success. In reality, there is no business as usual, no magic formula that leads to sustained high performance and financial success at companies. The long-term and repeated successes of high-performing companies are actually due to constant reinvention — their agility.
Most entrepreneurs start with a culture of agility and a commitment to be responsive to the changing needs of the clients/customers. But as organizations grow and evolve, much of that entrepreneurial daring is replaced with a dogged fixation on “The Plan” — or, in the other extreme, thrashing around in the face of crisis and trying to adapt with urgent, costly and often ineffective crisis management and organization restructuring.
An examination of hundreds of businesses over 20 years of operations has shown us that rather than digging in their heels, successful companies do a better job at four things: establishing a climate for revising strategies, perceiving and interpreting environmental (external) trends and disruptions, testing potential responses, and implementing the most promising changes.
They have a culture of continuous agility. In essence, they have “agility routines.”
With recent research suggesting that the expected life of a new American company is about six years, entrepreneurs who have enjoyed some success, but want to take their business to the next level, must adopt a culture of agility to survive.
New business owners must first focus on establishing an aspirational purpose, developing a widely shared strategy and managing the climate and commitment to execution. While it sounds obvious, too many entrepreneurs are focused instead on goals: being number one in the market or meeting threshold monthly financial targets.
An agile organization develops a dynamic strategy with change in mind and has a process for modifying the strategy in the face of change, based on aspirational targets — beyond profitability — that unify and inspire stakeholders.
Related: The One Thing You Need to Keep Your Business Relevant
Next comes the process of broadly, deeply and continuously monitoring the environment to sense change and rapidly communicate these perceptions to decision-makers, who interpret and
formulate appropriate responses.
Agile organizations use the perceiving routine to assess what is happening in their environment better, faster and more reliably than their competition. Entrepreneurs, in particular, fall in love with their products and ideas, and with the original business plans that back them. But this does not allow organizations to be agile. After all, if you’re producing croissants and the marketplace suddenly wants donuts, you’d better come up with a cronut & quickly.