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Managing Long Puts

Managing Long Puts

Key Points
  • Many traders don't like short selling because the risk is unlimited.

  • Another bearish alternative is a long put option but the difference is your potential losses are limited to the price paid for the put.

  • But what happens if the stock goes up instead of down?

  • We'll look at how you might adjust your original long put strategy to potentially recover some or all of your losses, or turn a losing trade into a winning one.

If you're bearish on a stock, you could enter a short sale, or you could buy a long put option—giving you the right (but not the obligation) to sell the stock if it reaches the specified price during a specified amount of time.

While both the short sale and the long put are bearish trades, one key benefit of the option strategy is that if you're wrong (and the stock goes up) your losses are limited to the price paid for the put. On the other hand, the losses on a short sale can be unlimited.

In addition, these two strategies have the following differences:

  • Short sales require you to borrow stock from an owner, which might not be possible since some shares are hard to borrow.
  • Small price increases in a short stock position may eventually be recovered, whereas similar increases could cause a put option to become completely worthless.
  • A short stock position can often be maintained for long periods of time, whereas long options always expire.
  • Short stock sellers are required to pay dividends (if any) to the share owners, whereas owners of long put options have no such obligation.

If you think a long put option may be better suited to your needs, keep reading.

What to keep in mind about a long put

While a long put position may seem like a relatively simple trade, it's actually more complicated than it appears. Long puts increase your leverage, which can result in a larger profit (from a percentage standpoint) than a short stock sale, but you generally have to be right about the direction of the stock, the magnitude of the move, and often the timeframe.
 
If you're wrong about any of these items, the option can lose value and eventually expire worthless, resulting in a total loss. That's the bad news. The good news is, just because you bought a put option and the stock price has not gone down, all hope may not be lost. It may still be possible to "manage" the position for a slightly modified expectation.

How does it work?

Let's walk through some examples. Assume it's August 31, 2014, you are bearish on XYZ and it is currently priced at $87.50. Rather than short selling 1,000 shares of XYZ, you make the following trade:

Buy 10 XYZ Oct 85 puts @ $1.25 (to open)

Net cost = -$1,250 (1.25 x 10 x 100)
Days until expiration = 51
Breakeven = $83.75 (strike price - options premium)
Max loss = -$1,250 (cost of the trade)
Max loss occurs at $85 or above, at expiration
Max gain = $83,750

Commissions, taxes and transaction costs are not included in this discussion. Please be aware that these costs can affect the final outcome significantly, and should always be considered.

Your original long put position

Your original long put position

Source: Schwab Center for Financial Research.

Two weeks later, XYZ has increased to $89 and your puts have dropped to $.50. As a result, you currently have an unrealized loss of -$750. What do you do?

First, reassess your opinion of XYZ and ask yourself the following questions:

  • Is my original price target still valid?
  • How bullish or bearish am I on this stock? Am I still as bearish as I was? Slightly less bearish? A lot less bearish? Or have I turned bullish?
  • Is it possible to raise my breakeven price?
  • Should I lower my profit expectations?
  • Am I willing to spend and risk additional money to adjust this trade?
  • Would it be better to close my position and cut my losses?

There are many possible ways to manage your original position, but your answers to these questions may help determine what action best suits your forecast and situation.

The simplest solution is to just sell your puts to close, take your $750 loss and be done with it. For more creative alternatives, read on.

A little less bearish

If you are a little less bearish than before, you might consider converting the original long put position into a bearish put spread by selling some lower strike puts.

Buy 10 XYZ Oct 85 puts @ $1.25 (to open) ◄original position
Sell 10 XYZ Oct 80 puts @ $0.25 (to open)

Net credit = $250 (.25 x 10 x 100)
Days until expiration = 37
Breakeven = $84 (original breakeven + new credit) or ($83.75 + $.25)
Maximum loss = -$1,000 (net cost of both trades) or (-$1,250 + $250)
Maximum loss occurs at $85 or above at expiration (both options expire worthless)
Maximum gain = $4,000 (difference in strikes – net cost of both trades) or ($5,000 - $1,000)
Maximum gain occurs at $80 or below at expiration (stock is bought at 80 and sold at 85)

Net new position: bearish put spread

Net new position: bullish put spread

Source: Schwab Center for Financial Research.

The effect of turning your long put position into this bearish put spread is by forgoing any additional profit potential below $80, the maximum potential loss is reduced by $250 (to $1,000), the breakeven price is raised by .25 points (to $84), and your unrealized loss is reduced by $250 (to $500).

A lot less bearish

If you are a lot less bearish than before, you might consider closing the original long put position, and creating a bearish put spread by reversing the original position and purchasing some puts with a higher strike price.

Buy 10 XYZ Oct 85 puts @ $1.25 (to open) ◄original position
Sell 10 XYZ Oct 85 puts @ $0.50 (to close)
Sell 10 XYZ Oct 85 puts @ $0.50 (to open)
Buy 10 XYZ Oct 90 puts @ $2.00 (to open)

Net debit = -$1,000 ((0.50 + 0.50 – 2.00) x 10 x 100)
Days until expiration = 37
Breakeven = $87.75 (long strike price - net cost of all trades) or ($90 - $2.25)
Maximum loss = -$2,250 (net cost of all trades) or (-$1,250 + $500 + $500 - $2,000)
Maximum loss occurs at $90 or above at expiration (all options expire worthless)
Maximum gain = $2,750 (difference in strikes – net cost of all trades) or ($5,000 - $2,250)
Maximum gain occurs at $85 or below at expiration (stock is bought at 85 and sold at 90)

Net new position: bearish put spread

Net new position: bearish put spread

Source: Schwab Center for Financial Research.

The effect of this new (higher strike) bearish put spread is that while there is an additional upfront cost of $1,000, you must be willing to forgo any additional profit potential below $85, the breakeven price is raised by four points (to $87.75) and XYZ has to be above $90 (up from $85) at expiration in order to sustain the maximum loss. Keep in mind, that with this new strategy, the maximum gain is only $2,750 (rather than $83,750).

You are now bullish

If you've completely changed your perspective on XYZ and are now bullish, you might consider converting the original long put position into a bullish put spread by selling some higher strike puts.

Buy 10 XYZ Oct 85 puts @ $1.25 (to open) ◄original position
Sell 10 XYZ Oct 90 puts @ $2.25 (to open)

Net credit = $2,250 (2.25 x 10 x 100)
Days until expiration = 37
Breakeven = $89 (short strike - net credit from both trades) or ($90 - $1)
Maximum loss = -$4,000 (difference in strikes - net credit from both trades) or ($5,000 - $1,000)
Maximum loss occurs at $85 or below at expiration (stock is bought at 90 and sold at 85)
Maximum gain = $1,000 (net credit from both trades) or (-$1,250 + $2,250)
Maximum gain occurs at $90 or above at expiration (all options expire worthless)

Net new position: bullish put spread

Net new position: bullish put spread

Source: Schwab Center for Financial Research.

Now, the stock is already moving in the right direction, and at the current price of $89 is already at your new breakeven price. Your original strategy was for XYZ to fall below $85, but if that occurs now, you will sustain your maximum loss. The new bullish put spread strategy brings in a net credit, but your maximum potential loss actually increases by $2,750 (from $1,250 to $4,000). In addition, your risk has increased and your maximum profit is now limited to only $1,000 (versus $83,750 previously), which occurs if XYZ is above $90 at expiration.

Stock stays flat

If you now feel that XYZ will probably stay where it currently is, you might consider a neutral strategy called a long put condor spread. To do this, first reverse your original position by selling to close your 85 strike puts. Then, create the condor by buying 80 strike puts, selling 85 strike puts, selling 90 strike puts and buying 95 strike puts.

Buy 10 XYZ Oct 85 puts @ $1.25 (to open) ◄original position
Sell 10 XYZ Oct 85 puts @ $0.50 (to close)

Buy 10 XYZ Oct 80 puts @ $0.25 (to open)
Sell 10 XYZ Oct 85 puts @ $0.50 (to open)
Sell 10 XYZ Oct 90 puts @ $2.25 (to open)
Buy 10 XYZ Oct 95 puts @ $6.00 (to open)

Net debit = -$3,000 (0.50 – 0.25 + 0.50 +2.25 – 6) x 10 x 100
Days until expiration = 37
Lower breakeven = $84.25 (lower middle strike – max gain) or ($85 – $0.75)
Upper breakeven = $90.75 (upper middle strike + max gain) or ($90 + $0.75)
Maximum loss = -$4,250 (net cost of all trades) (-1.25 + 0.50 – 0.25 + 0.50 +2.25 – 6) x 10 x 100
Lower maximum loss occurs at $80 or below at expiration (1,000 shares are sold at $80 and bought back at $85, in addition 1,000 shares are bought at $90 and then sold at $95)
Upper maximum loss occurs at $95 or above at expiration (all options expire worthless)
Maximum gain = $750 (middle strike - lower strike – net debit from all trades) or ($5,000 - $4,250)
Maximum gain occurs at any price between $85 and $90 at expiration (1,000 shares are bought at $90 and sold at $95)

Net new position: long put condor

Net new position: long put condor

Source: Schwab Center for Financial Research.

The effect of turning your original long put position into a long put condor spread is that if the stock remains relatively flat (near $87.50) you'll end up in the profit zone, as this strategy has a 6.5 point profit range from $84.25 – $90.75. However, if the stock moves above or below this range, you will sustain losses. If XYZ is above $95 or below $80 at expiration, you will sustain your maximum loss of $4,250.

Because the additional trades needed to create this condor require an additional $3,000 capital investment, you should not consider this strategy unless you have a high degree of confidence that XYZ will remain within a few dollars of its current price through expiration.

Compare your "options"

The matrix below summarizes some of the potential adjustments you can make to your long put trade:

Managing long puts decision matrix

Managing long puts decision matrix

There are many other possible ways to adjust a trade that hasn't quite worked out as you expected. Hopefully, these examples have given you some ideas for the next time it happens.

I hope this enhanced your understanding of long puts. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Next Steps

Talk to Us
To put these strategies to work in your portfolio:

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.
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