How Do Puts Work?
The normal rule of thumb that people argue is that long puts are used if you are bearish. But, just as calls don’t always pay you on a rally, being long a put doesn’t always pay if the market sells off. If implied volatility is high and the break is small or takes time, the put will not pay off the way you expect.
Focusing purely on the directional element, long puts are short Delta. The general view is that you would buy a put if you are bearish or looking to hedge a bullish bet. We simply have to remember that while that is the intent, the long put position does not always work when the market sells off.
A graph of a $17.50 put with Implied Volatility of 50% and 30 days to expiration (and as time passes) follows:
One can see clearly that at expiration or for puts where the strike is far above the current stock price, the option acts like a short stock position. At or above the strike price, and the put owner will lose the premium paid but no more. So, on a large rally, the long put will act as a stop to your position – this is a nice feature. That remains one of the most important strengths of long option positions – when you enter the trade, you have defined risk that tells you exactly how much money you can lose if you are wrong.
Let’s look at this with leverage just as we did with the call position: you may have a situation where you are willing to lose $500, but the premium of the put is only $100. If you are willing to lose more than the premium of 1 put option, you can buy multiple options and add leverage to the downside. This is the second key benefit of long option positions. See below for a graph of 5 puts vs the return of 100 shares of stock:
But, there are big risks. Remember what happens if the stock does not move much. Let’s focus in on a tight window around the current stock price to see why long options is not always preferred to a stock position:
As you can see, there are scenarios where a stock can go lower, but because that move takes time, the put owner is worse off in puts than having been short stock. Every trade construction will have trade-offs. To get defined risk and leverage, one has to sacrifice the returns from smaller moves in the equity.
Once again, as you look at the risk/reward profile of the trade, the key here is that as you add options, you can’t just look at the reward if you reach your price target. You have to also factor in the risk associated with small price moves that could erode your option value.