Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we are going to briefly describe the differences between a short put option and a long put option. This gets back to some of the options basics that I think are really important foundational elements that you have to understand if you want to start trading options or trading for a living.
Let's talk about a long put option actually first. Long options are some of the first option strategies that you learn because they're very easy for most people to understand conceptually. With a long put option, you are doing two things. One, you are paying money to enter the position and two, in exchange for paying money to enter the position at a particular strike price, you have complete upside potential in the sense that if the stock continues to move down, you could make a lot of money on that contract. Long put options profit from a quick and rapid decline in the underlying stock price or a rise in volatility. What would happen with a long put option is if a stock was trading at say $100, you might buy a 98 strike put option for $1. And so, your hope is that the stock goes down below at least your breakeven point which is around $97. The strike price of the option contract which is $98 plus the premium that you paid to get into it gets your breakeven down to around $97. You can see that it would actually make money as long as the stock were to go down as low as $97 or lower. Every $1 or $.50 that the stock goes below that level, then you start making money on your long put option. Long puts are really popular on the outside for risk hedging and for portfolio hedging, but the reality is that this type of insurance contract which is exactly what a long put option is, is actually very costly for your portfolio unless you have the ability to pinpoint exactly when the stock is going to start dropping. Very much like insurance on your house or your vehicle, it's really not in your best interest to have insurance unless you get into a car accident. It only serves its purpose when the markets crash or when the stock crashes, again, which you don't know when that's going to be or at what velocity that stock is going to go down.
Now, let's contrast this with a short put option. Using the same strike prices from our example, if we were to take the other side of this trade and be a short put seller, then what we would be doing is two things. We would be collecting a premium from the long put option buyer (in this case, $100 from our example) and in exchange for collecting this premium which is the maximum amount of money that we can make, we take all of the risk that's associated with the stock potentially going below that strike price. If we were to sell a 98 strike put option which is the same strike price as the put option buyer that we had in the example and we collected $1 in premium which is $100 in notional value for the option contract, that means that our breakeven price is also $97 on the stock price. As long as the stock stays above $97 and assuming it's trading around $100, we’ve got about a $3 cushion, so that anywhere above that $3 range or above $97, then we make that $100 premium that we collected from the long put option buyer. It’s a very similar concept as insurance. When you are an insurance company and you sell an insurance policy to somebody and you ensure their vehicle or their house against catastrophic loss, well, if the house never burns down or if the vehicle never gets into an accident, the insurance company keeps that entire premium for the duration of the contract. It’s very much the same, similar concept. As an option seller or a short put option seller, what you're doing is you are trading a lower potential payout for a much higher probability of success. And so, that is the key, we believe to how you can generate long-term, sustainable growth and income in your portfolio, is to do strategies like short selling puts which can seem scary on the outside, but statistically and market wise, from all of our back-testing research as well as many other outside companies and firms is one of the more profitable strategies you can employ.
Hopefully this helps out. Again, it’s just a very basic overview of both of these strategies. We do have much more training inside of the Option Alpha platform. You can just search long puts or short puts. There’s tons of training videos, other podcast, as well as some live trading videos that we've recorded of us actually executing some of these strategies inside the platform. If you guys have any questions, let me know and until next time, happy trading.