Understanding the Difference Between Short and Long Puts
The election is quickly approaching, which will no doubt leave many to speculate on how the market will react, regardless of the outcome. With that being said, a return to the basics may help novice traders understand the fundamentals of options trading. So, today we'll be taking a look at the difference between short put and long put options, and how to shed some light on how the fundamental differences can help you make the best options moves.
First, let’s review what a put option is. A put option is a contract between a buyer and a seller that gives the holder the right, but not the obligation, to sell shares of an underlying security at a set price -- known as the strike price. Like call contracts, put option contracts have expiration dates, so the option must be exercised before or on the expiration date lest the option expire worthless.
In short, if an investor executes the short put strategy, then the investor would sell a put option, and assume the role of the option writer. The phrase "short put" simply refers to a put option that has been sold to open. On the other hand, if an investor utilizes a long call strategy, they can assume the role of holder if they think a stock’s price will decrease and decide to buy a put option.
Maybe an example will help illustrate the differences better. For the long put strategy, let’s say ABC stock has a price per share of $100, and an investor buys one put option with a strike price of $95 set to expire in one month. The expectation for a long put is that the stock price will fall to or below $95 in the next month. As the holder, the investor has the right to sell 100 shares of ABC at that strike price until the expiration date, with one contract equal to 100 shares of ABC. Let’s also say that the premium for the put option is $3 per share, so the holder pays $300 for the put option to the option writer. Thus, $300 is the maximum amount the holder can lose. Now, assume the price of the stock falls to $90 in that month, so the holder can exercise the put option and sell at $95 instead of $90. The holder can buy the shares of the stock at the market price, then immediately sell the shares at $95, generating a profit of $5 per share for the holder. Of course, if the share price never falls to the strike price, then the put option expires worthless, and the holder loses the $300 premium.
Now let’s take that same example and apply it to a short put strategy. Stock ABC has a price per share of $100, and an investor sells one put option with a strike price of $98 that expires in a month. The investor expects the price of the stock to stay above $95 within the next month, and the investor receives a premium of $3 per share for writing the put option – a total of $300. If the stock never closes below $98, the option expires worthless and the writer profits $300 because of the premium. However, if the price fell to, let’s say, $95 within the month, then the option would have been exercised and the writer would be obligated to buy the shares of stock at $98 instead of $95 – or a loss of $3 per share for the option writer.
When dealing with long put options, the most you can lose is your initial cash outlay. In the former case that would be $300; however, in the latter, risk is theoretically unlimited as growth potential can never truly be capped – although that is unlikely. And there’s also volatility to consider. A long-put options holder will pay a richer premium when implied volatility (IV) is high. Meanwhile, put options are much like calls, where a dividend-paying stock will price in the impact of any dividend set to be paid during the lifespan of the contracts; however, scheduled dividend payments lower the cost of call options, while these same occurrences raise the cost of put options.
In short, investors typically take the long-put route if they think a stock’s price will fall, and to speculate or hedge a portfolio. The biggest advantage to long puts is there downside risk is limited. A short put trader sells or writes a put option on a security, and the investor can quickly profit on the increase of the stock’s price by collecting the premium.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.