Image source: Getty Images.
Continue Reading Below
There are plenty of ways to profit on a stock's movement beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
One of the most basic positions that an investor can take is a long put.
The basic setup
A long put is simply owning a put option. You would purchase a put option if you believe that the stock is going to fall, since the value of a put goes up if the underlying stock price goes down. However, any option has the risk of expiring completely worthless upon the expiration date, so buying options is considered a speculative strategy.
Continue Reading Below
For example, let's say a stock is trading at $50. If you believe that the stock will go down, you could consider purchasing a $45 put. Let's say that the premium for that put is $2.
Maximum loss: premium paid
Any time that you purchase an option, the most that you can lose is the premium that you paid for the option. This is true for both calls and puts. This occurs if the option is out-of-the-money upon expiration, in which case it expires worthless.
In this example, you would lose the full $2 in premium if the stock closes upon expiration above $45, since the put would then be worthless.
Maximum gain: strike price minus premium
The lowest a stock price can go is $0. The best-case scenario for a bearish investor purchasing a long put is that the stock goes to $0. Under this scenario, you could exercise and sell the stock at the strike price, but the stock is worth nothing.
In this example, if the underlying stock went to $0, you would be able to sell a stock with no value to the counterparty for $45, for a gain of $45. After factoring in the premium cost of $2, your net gain would be $43.
Breakeven: strike price minus premium
The breakeven on a long put is the strike price minus the premium. If the stock closes at this price upon expiration, the gains associated with the trade will exactly offset the upfront premium paid.
In this example, if the stock closed at $43, you would gain $2 on the trade itself (buying at $43 and selling at $45). This would offset the $2 in premium paid upfront.
The $15,834 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $15,834 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.