Buying Put Options

The purchase of a Put option (long) is used by the investor that believes the underlying asset will decrease in value.  The Put option reward potential is maximized if the value of the underlying falls to zero.  The maximum risk of the Put option is the premium paid for the option.

An investor generally will purchase Puts for two reasons.  The first reason is to speculate on a bearish move in the underlying asset. Rather than shorting the stock, and having substantial risk to the upside, the investor will purchase the Put with the objective of generating a return as the underlying drops.  The second reason an investor might purchase a Put option is to protect a long stock position.  Remember, the Put option provides the buyer the right, but not the obligation to sell an underlying asset at a set price for a specified period of time.  This allows the stock investor to hold the stock, but should it drop, the investor can exercise the Put and sell the stock at the Put strike price, regardless of how much the stock has declined.

There are three ways to exit a long put option position.  If at expiration, the underlying asset is trading above the strike price of the Put, the option will expire worthless from the account. No action is necessary.  If at or before expiration, the underlying is trading below the strike price of the Put, the investor might chose to sell the option (the identical position in the account), back into the market.  If the option premium is worth more than what the investor originally paid, the investor will have a profit.  The third way to exit a Put option, in the case of the long stock holder, is to exercise the option.  If the underlying asset is trading below the strike price of the Put, the investor can exercise the Put and force a Put seller (short) to buy the stock at the strike price.  This would have locked in a higher selling price for the stock and the investor would have protected their downside.

Puts can be a less risky way to take advantage of an expected move to the downside when compared to a short stock position.  The investor has limited risk, but must be correct on the direction and time frame in which the move should take place.