Covered Puts: Understanding The Covered Put Trading Strategy

Covered Puts: Understanding The Covered Put Trading Strategy
Covered Puts: Understanding The Covered Put Trading Strategy

Covered Puts are bearish neutral strategy.  As an investor, you follow this strategy when the price of the stock/index remains range-bound or moves down. 

A covered put includes a short stock/index contract together with a short put contract on stock/index options.

What Is Covered Puts?

A covered put is a bearish strategy that is essentially a short version of a covered call.  In a covered put option, if you have a negative outlook on a stock and are interested in shorting it, you can combine a short position on the stock with a short put position. 

This creates some immediate income upfront from the premium received from writing the puts.  It also limits your potential profit from a short position, because if the stock declines below the strike price, you will subsequently purchase the stock through the exercise of the option and close out your short position.

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How Do Covered Puts Work?

One variant of the closed put strategy is to write deep put-puts.  These options trade close to their intrinsic value — intrinsic value = put strike price — stock price. 

The option premium earned can then be invested in a risk-free interest-paying asset or other investment opportunities.  With a closed put strategy, the investor’s maximum profit from a short stock position is limited by the short put. 

Since the investor is writing a put option, there is a possibility of assignment.  When an assignment occurs, the investor must purchase the underlying shares at the exercise price.  This will cover the short stock position and unfold the entire strategy. 

However, as detailed in the payoff chart later in this article, the risk of a covered put strategy occurs when the stock rises above the strike price of the put.  Since the investor also has a short position, the risk is perpetual.

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When To Use A Covered Put

Covered puts strategy can be used to arbitrage a put option that is considered overvalued, which is commonly found in American-style options due to the exercise right to expiration feature. 

Thus, by simultaneously placing in-the-money puts and shorting shares, investors can invest the proceeds in an interest-paying instrument. 

Ultimately, if the put option is exercised, the position is liquidated at break-even, and the investor keeps the interest earned, if any.

  Investors who use a covered put strategy typically look for stocks that will decline steadily or slightly over the life of the option. 

A stock with a neutral outlook can also be a good candidate for this strategy.  However, this is certainly not an option strategy for bullish stocks.

ALSO CHECK: SELL TO OPEN VS SELL TO CLOSE: Detailed Comparison

Difference Between Covered Puts And Naked Puts

The most significant difference between a covered put and a cash (or unsecured) bare put is risk.  Take a look at the two profit and loss charts below.  The first is a covered put. 

Note that the directional bias is from stagnant to bearish.  Because a short put obligates the put seller to buy the stock at the strike price of the put, thus offsetting the short position in the stock, returns are limited. 

This restricted return is the difference between the proceeds from shorting both the stock and the put and the exercise price of the put.

ALSO CHECK: Market Cycle: All You Need To Know About The Stock Market Cycle

Writing Covered Puts

Writing covered puts is a bearish options trading strategy that involves selling a put option on an ATM or lot below the market price while simultaneously shorting 100 shares of the underlying stock. 

Selling a put option requires credit, which is then used to extend the break-even point higher than you originally sold the stock.  For example, if you are short a stock for $50 and selling the put option received a $1.50 credit; your new breakeven price would be $51.50 for the total position. 

The payoff chart of this strategy looks identical to simply using a short call above the market and is less capital intensive.

ALSO CHECK: Bull Trap: Definition and how to avoid getting into one

Selling Covered Puts For Income

Selling (also called writing) a put option allows the investor to potentially own the underlying security both in the future and at a better price. 

In other words, selling put options allows market players to gain leverage, with the added benefit of potentially owning the underlying security both in the future and at a price below the current market price.

ALSO CHECK: BUY TO CLOSE: Definition And Trading Guide

How To Sell Cash Covered Puts

A cash-covered put is a two-part strategy that involves selling an out-of-the-money put option while putting aside the capital needed to purchase the underlying stock at the option’s strike price. 

The objective of this strategy is to purchase the stock at a price below the current market price if the option is assigned to you.

By selling a cash-covered put, you can receive money (a premium) from the buyer of the option.  The buyer pays this premium for the right to sell the stock to you at any time before expiration at the strike price.

 The premium you receive allows you to lower the total purchase price if you are awarded the shares.

How To Sell A Put Option

Selling a put option allows you to receive a premium from the buyer of the put.  No matter what happens later in the trade, as a put seller, you can always keep the premium paid up front.

Compared to buying the stock outright, where you pay at the current market price and have guaranteed ownership, selling a put option allows you to earn some income and potentially own the stock at a lower price.

Conclusion

A covered put strategy is a neutral to bearish strategy as the investor expects the stock to decline or remain neutral.  When the stock falls, the investor gets the stock at a short strike price.  This covers liabilities for shares that have been shorted. 

The investor retains the initial premium received from the sale of the covered put.  If the stock goes up, the investor keeps the premium, but he still holds the liability of shorting the stock and can take a loss to close out the short position. 

If a short put expires without an assignment, the investor can try to sell another covered put with a different strike for the next expiration month.

Covered Puts FAQs

What Does It Mean To Write A Covered Put?

If you write a covered put, that is, you hold a short position on the underlying stock, then after the strike price the put is covered.  For every dollar that the stock price falls, your cost of getting the put (that is, buying the stock by exercising the option) is exactly offset by the reduction in the stock you hold.  In other words, for the writer of the covered put, the shares he/she puts up balance the shares he/she would have to put up to cover the short position on those stocks, so he/she balances out pretty well. 

Does Covered Put To Protect You Against The Rise In Price Of The Underlying Stock You Hold Short?

Like a covered call, a covered put will in no way protect you from the rise in (in this case) price of the underlying stock you’re holding.  But if the stock price goes up, the put itself is safe.  Thus, the put writer is insured against losses due to the put.

Is It Risky To Write Covered Put?

Although the writer of a covered put does not risk losing huge sums of money by writing the puts, there is the risk of losing large profits as well as the risk of losing a short stock position.  The risk of loss of profit is quite simple: if the stock price has fallen significantly and the put options are nearing expiration with a strike price that is even slightly out of the money, those puts will be exercised before expiration. 

References

fidelity.com –  Cash-covered puts in focus

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