Series 4

Introduction - Buying Puts

An investor who purchases a put believes that the underlying stock price will fall and that they will be able to profit from a decline in the stock price by purchasing puts. An investor who purchases a put can control the underlying stock and profit from its price decline while limiting their loss to the amount of the premium paid for the puts. Buying puts allows the investor to maximize their leverage while limiting their losses and may realize a more significant percentage return based on their investment when compared to the return that could be realized from shorting stock. When looking to establish a position the buyer must determine:

  • Their Maximum Gain
  • Their Maximum Loss
  • Their Breakeven
Maximum Gain Long Puts

An investor who has purchased a put believes that the stock price will fall. There is, however, a limit to how far a stock price may decline. A stock price may never fall below zero. As a result, the investor who believes that the stock price will fall has a limited maximum gain. To determine the maximum gain for the buyer of a put, use the following formula:

Maximum Gain = Strike Price – Premium

Maximum Loss Long Puts

Whenever an investor is long or owns a stock, their maximum loss is always limited to the amount they invested. When an investor purchases a put option, the amount they pay for the option or their premium is always going to be their maximum loss.

Determining The Breakeven for Long Puts

Whenever an investor has purchased a put, they believe that the stock price will decline. In order for the investor to breakeven on the transaction, the stock price must fall by enough to offset the amount of the premium paid for the option. At expiration the investor will breakeven at the following point:

Breakeven = Strike Price – Premium

Example:

An investor has established the following option position:

Long 1 XYZ May 30 put at 4

The Investor’s maximum gain, Maximum loss, and breakeven will be: Maximum Gain: $26 or $2,600 for the whole position (Strike price – Premium)

Maximum Loss $400 (The amount of the premium paid)

Breakeven = $26 = 30-4 (Strike price - premium)

If at expiration XYZ is at exactly $26 per share and the investor sells or exercises their option, they will breakeven excluding transactions costs.

Series 4 Exam Training - Securities Institute



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