Debit/Debit Spread Strategy:
Long Put

AKA: Put, Buying Put Options

ANALOGY/METAPHOR: Playing the Slot Machine at a Casino

ACTION: Buy 1 in the money (ITM), at the money (ATM), or out of the money (OTM) put option. And then hope like hell the stock immediately starts moving lower. That's essentially all there is to this strategy.

Like the long call, the long put is a wasting asset. It consists of intrinsic value if it's ITM plus time value. As time passes, the option will lose value through time decay, until eventually all time value is wrung from it. Strong moves to the downside, however, will more than make up for the loss of time value. A long put on a stock that moves significantly lower is a powerful leverage that can result in astounding double, triple, and sometimes quadruple digit gains.

DESCRIPTION: As a reminder, what you're literally doing by purchasing a long put is buying the right to sell 100 shares of stock at a certain price by a certain date (although you don't need to actually own any stock prior to buying the put). You do so because you believe that the stock will be lower by the time the option expires, and that, theoretically, you'll be able to pick up 100 shares in the future on the open market a lot cheaper than you can at the moment. By purchasing a Put Option instead of shorting 100 shares of actual stock, you tie up a fraction of the capital. Therefore your profits, and losses, will be magnified as you calculate your returns based on the investment cost of your option position rather than the investment requirements of 100 shorted shares of the underlying stock.

In practicality, using a long put by itself is a bet against the house in the hopes of hitting a jackpot. It's an aggressive bet on the near term downward move of a stock. If the stock remains flat, the value of the option steadily bleeds away. If the stock goes higher, the effect is more like that of a severed artery. The value of the option hemmorages and you can quickly see large, double digit losses. If you hold on to the option until expiration, and the stock closes above the strike price, you will lose every penny of your original investment.

But if the stock does what you hoped it would--move sharply lower--there's no more effective way to maximize huge returns than with a long put. The strategy may also be likened to being a quarterback who's blitzed on third down. Oh--you're also playing against a team that's allowed about five extra players. The most likely outcome is that you're going to get knocked on your ass.

If, however, you're lucky and you're able to get your pass off in time, there's a wide open receiver in the backfield with nothing between him and the end zone.

EXAMPLE: The XYZ Zipper Company has been trending lower recently and is now trading at $37/share. You believe that the company's fundamentals and technicals are both questionable and that the downward trend will continue. You purchase a $35 put expiring in one month for $1 (i.e. a $100 debit). This is an OTM put and consists solely of time value. If the stock closes anywhere above $35, the option will expire worthless.

But let's suppose you were right about the stock. Negative news is released--velcro sales are way up, which bodes ill for the zipper industry--and XYZ stock continues falling lower. On Expiration Friday, the stock is trading @ $33/share. Your $1 long put is now worth $2 per contract ($35/share you're eligibile to sell the stock for minus the $33/share it would now cost you on the open market).

If you would've shorted the 100 shares of stock in lieu of buying the put, you would've made $400, or a 10.8% return ($400 divided by the $3700 you originally sold the stock at is one way of calculating it--the other is $400 divided by the $3300 it's now worth, assuming you bought the stock back to close the position, a little over 12% calculated this way). But you also would've been exposed to theoretically unlimited upside risk in the stock. What if the company announced a major new contract with the military? What if Warren Buffett announced he was buying 10% of the company? What if a vast oil deposit was discovered on company property? Theoretically, the stock price has no ceiling and you could lose an unlimited amount of money.

But with the put, the most you could've lost was $100. And your ultimate return of $100 represents a 100% return on your invested capital.

VARIATIONS: Simply buying a long put is an inherrently risky strategy since the stock HAS TO make a strong move downward, and in a certain time period, for you to make money. It's also risky in that it's next to impossible to break even. You can almost bank on the assumption that you're going to get double digit returns. The only question is whether those returns will be negative or positive.

But like all option trading strategies, even a simple long put strategy can be made more or less risky. You can reduce risk by adjusting these factors:

1. The Strike Price - The deeper in the money (DITM) the strike price is, the more the put is comprised of intrinsic value rather than time value. And it's time value that kills the buyer of options. Intrinsic value means there's something of real value there, something that will remain on Expiration Friday even if the stock doesn't get to where you wanted it to go. Obviously then, an ITM put will require more capital upfront than its OTM counterpart, and on a percentage basis, the potential returns will be much less. But with an ITM option (and especially a DITM option), your risk of losing your entire investment is diminished.
2. The Expiration Date - In the same way, the farther out in time the Expiration Date is, the more time you allow the stock to move lower. The downside, of course, that the farther out in time the Expiration Date is, the more you'll have to pay for the option. That again equates to a larger capital investment and therefore a reduction, on a percentage basis, of your potential returns.

OTHER:

A couple of items:

First, I want to address a double standard or false logic that is routinely promoted in the advocation of buying put options (and other strategies as well). It's the double standard of hyping both the limitied capital risk aspect of the trade as well as the potentially huge percentage gains aspect. In short, you can't have it both ways. After a successful trade, you can't go around saying, "I just made a 100% gain in twelve days! And I only risked $500!" A 100% return on $500 is still only $500. That equates to a 10% return on a $5,000 dollar investment and a 1% return on a $50,000 investment. If you wanted a potential 100% return on your entire portfolio, then you'd have to put the entire thing at risk. It is possible to make money buying options. Many salmon make it all the way back upstream to spawn, which is very inspiring and speaks to the power of instinct and will. But don't forget the other lesson--most salmon don't make it.

Second, the long put and the long call option trading strategies are such similar strategies (practically, the only difference is the direction the trader hopes the underlying stock will move) that much of the descriptions and wording of each strategy will be redundant and even identical. It's no crime to plagiarize oneself. Plus it's difficult coming up with entirely new scenarios and misadventures for The XYZ Zipper Company.

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