Long Put Ladder Explained

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Long Put

What Is a Long Put?

A long put refers to buying a put option, typically in anticipation of a decline in the underlying asset. A trader could buy a put for speculative reasons, betting that the underlying asset will fall which increases the value of the long put option. A long put could also be used to hedge a long position in the underlying asset. If the underlying asset falls, the put option increases in value helping to offset the loss in the underlying.

Key Takeaways

  • Investors go long put options if they think a security’s price will fall.
  • Investors may go long put options to speculate or hedge a portfolio.
  • Downside risk is limited using a long put options strategy.

The Basics of a Long Put

A long put has a strike price, which is the price at which the put buyer has the right to sell the underlying asset. Assume the underlying asset is a stock and the option’s strike price is $50. That means the put option entitles that trader to sell the stock at $50, even if the stock drops to $20, for example. On the other hand, if the stock rises and remains above $50, the option is worthless because it is not useful to sell at $50 when the stock is trading at $60 and can be sold there (without the use of an option).

If a trader wishes to utilize their right to sell the underlying at the strike price, they will exercise the option. Exercising is not required. Instead, the trader can simply exit the option at any time prior to expiration by selling it.

A long put option may be exercised before the expiration if it’s an American option whereas European options can only be exercised at the expiration date. If the option is exercised early or expires in the money, the option holder would be short the underlying asset.

Long Put Strategy Versus Shorting Stock

A long put may be a favorable strategy for bearish investors, rather than shorting shares. A short stock position theoretically has unlimited risk since the stock price has no capped upside. A short stock position also has limited profit potential, since a stock cannot fall below $0 per share. A long put option is similar to a short stock position because the profit potentials are limited. A put option will only increase in value up to the underlying stock reaching zero. The benefit of the put option is that risk is limited to the premium paid for the option.

The drawback to the put option is that the price of the underlying must fall before the expiration date of the option, otherwise, the amount paid for the option is lost.

To profit from a short trade a trader sells a stock at a certain price hoping to be able to buy it back at a lower price. Put options are similar in that if the underlying stock falls then the put option will increase in value and can be sold for a profit. If the option is exercised, it will put the trader short in the underlying stock, and the trader will then need to buy the underlying stock to realize the profit from the trade.

Long Put Options to Hedge

A long put option could also be used to hedge against unfavorable moves in a long stock position. This hedging strategy is known as a protective put or married put.

For example, assume an investor is long 100 shares of Bank of America Corporation (BAC) at $25 per share. The investor is long-term bullish on the stock, but fears that the stock may fall over the next month. Therefore, the investor purchases one put option with a strike price of $20 for $0.10 (multiplied by 100 shares since each put option represents 100 shares), which expires in one month.

The investor’s hedge caps the loss to $500, or 100 shares x ($25 – $20), less the premium ($10 total) paid for the put option. In other words, even if Bank of America falls to $0 over the next month, the most this trader can lose is $510, because all losses in the stock below $20 are covered by the long put option.

Real World Example of Using a Long Put

Let’s assume Apple Inc. (AAPL) is trading at $170 per share and you think it’s going to decrease in value by about 10% ahead of a new product launch. You decide to go long 10 put options with a strike price of $155 and pay $0.45. Your total long put options position outlay cost is $450 + fees and commissions (1,000 shares x $0.45 = $450).

If the share price of Apple falls to $154 before expiry, your put options are now worth $1.00 since you could exercise them and be short 1,000 shares of the stock at $155 and immediately buy it back to cover at $154.

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Your total long put options position is now worth $1,000 – fees and commissions (1,000 shares x $1.00 = $1,000). Your profit on the position is 122% ($450/$1,000). Going long put options allowed you to realize a much greater gain than the 9.4% fall in the underlying stock price.

Alternatively, if Apple shares rose to $200, the 10 option contracts would expire worthless, resulting in you losing your initial outlay cost of $450.

Ladder Option

What Is a Ladder Option?

A ladder option is an exotic option that locks in partial profits once the underlying asset reaches predetermined price levels or “rungs.” This guarantees at least some profit, even if the underlying asset retraces beyond these levels before the option expires. Ladder options come in put and call varieties.

Do not confuse ladder options, which are specific types of options contracts, with long call ladders, long put ladders, and their short counterparts, which are options strategies that involve buying and selling multiple options contracts simultaneously.

How a Ladder Option Works

Ladder options are similar to traditional option contracts that give the holder the right, but not the obligation to buy or sell the underlying asset at a predetermined price at or by a predetermined date. However, a ladder option adds a feature that allows the holder to lock in partial profits at predetermined intervals.

These intervals are fittingly called “rungs” and the more rungs the price of the underlying asset crosses, the more profit locks in. The holder keeps profits based on the highest rung achieved (for calls) or the lowest rung achieved (for puts) regardless if the price of the underlying crosses back below (for calls) or above (for puts) those rungs before expiration.

Because the holder earns non-returnable partial profits as the trade develops, total risk is much lower than for traditional vanilla options. The trade-off, of course, is that ladder options are more expensive than similar vanilla options.

Example of a Ladder Option

Consider a ladder call option where the underlying asset price is 50 and the strike price is 55. Rungs are set at 60, 65, and 70. If the underlying price reaches 62, the profit locks in at 5 (rung minus strike or 60 – 55). If the underlying reaches 71, then the locked in profit increases to 15 (new rung minus strike or 70 – 55), even if the underlying falls below these levels before the expiration date.

As with vanilla options, there is time value associated with ladder options. Therefore, the traded price for call options is usually above the locked in profit amount, and declining as the expiration date approaches.

If the price of the underlying falls below any of the triggered rungs, again for calls, it almost does not matter to the price of the option because the partial profit is guaranteed. Although, this is an oversimplification because the lower the underlying moves below the highest triggered rung, the less likely it will be to rally back to exceed that rung and reach the next rung.

Protective Put

What Is a Protective Put?

A protective put is a risk-management strategy using options contracts that investors employ to guard against the loss of owning a stock or asset. The hedging strategy involves an investor buying a put option for a fee, called a premium.

Puts by themselves are a bearish strategy where the trader believes the price of the asset will decline in the future. However, a protective put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty.

Protective puts may be placed on stocks, currencies, commodities, and indexes and give some protection to the downside. A protective put acts as an insurance policy by providing downside protection in the event the price of the asset declines.

Key Takeaways

  • A protective put is a risk-management strategy using options contracts that investors employ to guard against a loss in a stock or other asset.
  • For the cost of the premium, protective puts act as an insurance policy by providing downside protection from an asset’s price declines.
  • Protective puts offer unlimited potential for gains since the put buyer also owns shares of the underlying asset.
  • When a protective put covers the entire long position of the underlying, it is called a married put.

How a Protective Put Works

Protective puts are commonly utilized when an investor is long or purchases shares of stock or other assets that they intend to hold in their portfolio. Typically, an investor who owns stock has the risk of taking a loss on the investment if the stock price declines below the purchase price. By purchasing a put option, any losses on the stock are limited or capped.

The protective put sets a known floor price below which the investor will not continue to lose any added money even as the underlying asset’s price continues to fall.

A put option is a contract that gives the owner the ability to sell a specific amount of the underlying security at a set price before or by a specified date. Unlike futures contracts, the options contract does not obligate the holder to sell the asset and only allows them to sell if they should choose to do so. The set price of the contract is known as the strike price, and the specified date is the expiration date or expiry. One option contract equates to 100 shares of the underlying asset.

Also, just like all things in life, put options are not free. The fee on an option contract is known as the premium. This price has a basis on several factors including the current price of the underlying asset, the time until expiration and the implied volatility (IV)—how likely the price is going to change—of the asset.

Strike Prices and Premiums

A protective put option contract can be bought at any time. Some investors will buy these at the same time and when they purchase the stock. Others may wait and buy the contract at a later date. Whenever they buy the option, the relationship between the price of the underlying asset and the strike price can place the contract into one of three categories—known as the moneyness. These categories include:

  1. At-the-money (ATM) where strike and market are equal
  2. Out-of-the-money (OTM) where the strike is below the market
  3. In-the-money (ITM) where the strike is above the market

Investors looking to hedge losses on a holding primarily focus on the ATM and OTM option offerings.

Should the price of the asset and the strike price be the same, the contract is considered at-the-money (ATM). An at-the-money put option provides an investor with 100% protection until the option expires. Many times, a protective put will be at-the-money if it was bought at the same time the underlying asset is purchased.

An investor can also buy an out-of-the-money (OTM) put option. Out-of-the-money happens when the strike price is below the price of the stock or asset. An OTM put option does not provide 100% protection on the downside but instead caps the losses to the difference between the purchased stock price and the strike price. Investors use out-of-the-money options to lower the cost of the premium since they are willing to take a certain amount of a loss. Also, the further below the market value the strike is, the less the premium will become.

For example, an investor could determine they’re unwilling to take losses beyond a 5% decline in the stock. An investor could buy a put option with a strike price that is 5% lower than the stock price thus creating a worst-case scenario of a 5% loss if the stock declines. Different strike prices and expiration dates are available for options giving investors the ability to tailor the protection—and the premium fee.

Important

A protective put is also known as a married put when the options contracts are matched one-for-one with shares of stock owned.

Potential Scenarios with Protective Puts

A protective put keeps downside losses limited while preserving unlimited potential gains to the upside. However, the strategy involves being long the underlying stock. If the stock keeps rising, the long stock position benefits and the bought put option is not needed and will expire worthlessly. All that will be lost is the premium paid to buy the put option. In this scenario where the original put expired, the investor will buy another protective put, again protecting his holdings.

Protective puts can cover a portion of an investor’s long position or their entire holdings. When the ratio of protective put coverage is equal to the amount of long stock, the strategy is known as a married put.

Married puts are commonly used when investors want to buy a stock and immediately purchase the put to protect the position. However, an investor can buy the protective put option at any time as long as they own the stock.

The maximum loss of a protective put strategy is limited to the cost of buying the underlying stock—along with any commissions—less the strike price of the put option plus the premium and any commissions paid to buy the option.

The strike price of the put option acts as a barrier where losses in the underlying stock stop. The ideal situation in a protective put is for the stock price to increase significantly, as the investor would benefit from the long stock position. In this case, the put option will expire worthlessly, the investor will have paid the premium, but the stock will have increased in value.

For the cost of the premium, protective puts provide downside protection from an asset’s price declines.

Protective puts allow investors to remain long a stock offering the potential for gains.

If an investor buys a put and the stock price rises, the cost of the premium reduces the profits on the trade.

If the stock declines in price and a put has been purchased, the premium adds to the losses on the trade.

Real World Example of a Protective Put

Let’s say an investor purchased 100 shares of General Electric Company (GE) stock for $10 per share. The price of the stock increased to $20 giving the investor $10 per share in unrealized gains—unrealized because it has not been sold yet.

The investor does not want to sell their GE holdings, because the stock might appreciate further. They also do not want to lose the $10 in unrealized gains. The investor can purchase a put option for the stock to protect a portion of the gains for as long as the option contract is in force.

The investor buys a put option with a strike price of $15 for 75 cents, which creates a worst-case scenario of selling the stock for $15 per share. The put option expires in three months. If the stock falls back to $10 or below, the investor gains on the put option from $15 and below on a dollar-for-dollar basis. In short, anywhere below $15, the investor is hedged until the option expires.

The option premium cost is $75 ($0.75 x 100 shares). As a result, the investor has locked in a minimum profit equal to $425 ($15 strike price – $10 purchase price =$5 – $0.75 premium = $4.25 x 100 shares = $425).

To put it another way, if the stock declined back to the $10 price point, unwinding the position would yield a profit of $4.25 per share, because the investor earned $5 in profit—the $15 strike less $10 initial purchase price—minus the 0.75 cents premium.

If the investor didn’t buy the put option, and the stock fell back to $10, there would be no profit. On the other hand, if the investor bought the put and the stock rose to $30 per share, there would be a $20 gain on the trade. The $20 per share gain would pay the investor $2,000 ($30 – $10 initial purchase x 100 shares = $2000). The investor must then deduct the $75 premium paid for the option and would walk away with a net profit of $1925.

Of course, the investor would also need to consider the commission they paid for the initial order and any charges incurred when they sell their shares. For the cost of the premium, the investor has protected some of the profit from the trade until the option’s expiry while still being able to participate in further price increases.

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