When a trader is fairly bearish on a stock, they can explore a long-term put option. The lower is the strike price, the more bearish is the strategy. The profit, in this strategy, tends to rise when the markets fall. The loss, however, is limited to the amount of premium paid. Generally, these options are taken when a trader is certain of long-term decline.
The breakeven point for the trader will be the option’s strike price minus price paid (premium) for the option. And for each point below break-even point, the profit rises marginally.
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For instance, when the stock price of company ‘A’ ranges between ₹80 and ₹90. A trader Mr Ali believes that the share price of ‘A’ will decline sharply in the forthcoming months – but not clear as to when, So, Mr Ali buys a long-term put option with a strike price of (say) ₹80 for a premium of ₹5. Now, to be able to make money, the price should fall below ₹80, and since he paid a premium, the price should ideally be at least ₹75 ( ₹80-5), for Ali to break-even.
And if the price slides to ₹60, he stands to make a profit of ₹15 on each share. If he bought the long-term put option on 100 shares, his profits will amount to ₹1,500 (15 X 100).
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Advantages and Disadvantages
Buying a long-term put can be compared with short selling since in both cases, traders make money on stock market falls. However, in short selling, a trader has to borrow the stock unlike in a put option – where the trader only pays a commission to buy the ‘right to sell’. Also, the risk in a long-term put is limited only to the commission paid, whereas short selling carries unlimited risk.
On the other hand, the put option has one disadvantage i.e. it has a limited time span. And if the stock price does not fall below the strike price before the date of expiry, the risk does not pay off. And the trader will lose the premium he paid to buy the options.
To summarise, the long term put option can be seen as a money-making option when the stock price moves southward – at least below the breakeven point. But the bet pays off only when the projection of stock price movement turns out to be correct.