What Are Covered Puts (An Alternative Options Strategy)

Derivatives like options can be risky securities to trade especially if you don’t have a strategy. For many traders during the pandemic years, options were used to speculate on volatile stocks. But derivatives like options aren’t just for leveraged speculation — many investors use options to hedge their equity exposure to help mitigate losses. 

One such strategy is the covered put, which involves writing put options for stocks an investor has already shorted. Before you should consider writing with a covered put strategy, you must have a thesis and the platform tools to execute the trades.

Covered Puts Explained

When executing a covered put trade, the participant is actually making two separate transactions: shorting a stock and then selling a put option in the money — at the money (ATM) or out of the money (OTM) — on that underlying stock. Covered puts may be considered when investors have a market-neutral or slightly bearish slant and want to limit their downside risk by capping some profit. Premium from selling the put can also be invested into an interest-earning vehicle. Covered puts typically benefit when the stock is range-bound and drops slightly but not enough to make the short position more profitable on its own.

Example of Covered Puts

An investor shorts 100 shares of XYZ stock for $143. Borrowing and then selling 100 shares at $143 credits $14,300 to the account. The investor then writes an XYZ put option with a strike price of $140 with expiry a month out, earning a $3.45 premium (multiplied by 100 because an option contract typically controls 100 shares). The account now has a balance of $14,645.

If XYZ shares decline to $138, the option buyer can exercise the contract and ‘put’ the shares on the writer, meaning the XYZ short position is liquidated for $13,800 because the 100 shares are assigned to the writer of the put option . As a result, the writer keeps a total profit of $845 ($500 gain on the short position, plus the $345 in option premium). But most investors use covered put strategies to invest the proceeds gained from the premiums into interest-earning securities and then return the initial cash to the broker to close the short sale.

What happens if the share price doesn’t move in the expected manner? Let’s say the price of XYZ stock doesn’t decline but instead rises to $150. The put option will expire worthless at $150, which allows the writer to pocket the $345 premium. However, the short position is now underwater and closing 100 shares at $150 would cost $15,000. Since the option writer has an account balance of $14,645, exiting the position would result in a net loss of $355.

Covered Put vs. Covered Call

A covered put strategy is when an investor writes a put option against a stock they’ve already sold short, hoping to earn interest while the share price declines or stays steady. Covered puts are said to be market-neutral to slightly bearish because a slight decrease in the underlying stock price may create potential profit. Too much of a decline would actually take some off the table —  the short position alone would work better in instances of significant stock price declines.

A covered call is a market-neutral or slightly bullish options trading strategy. A covered call trade involves purchasing 100 shares of stock and then writing an ATM or OTM call option with a short duration. If the stock price rises, the option buyer could exercise, and the writer’s shares will be called away, allowing the writer to keep the option premium as profit but lose the underlying shares. Conversely, if the share price declines, the stock position loses value, but the option expires worthless, the writer of the option can still keep the premium.

Cash-Secured Put vs. Covered Put

When selling a covered put, the investor making the trade is both writing a put AND shorting the underlying stock. This scenario creates a limited window for profit, as a significant decline in price limits the upside, and a price increase can create unlimited losses.

A cash-secured put is when an investor writes a put option and then sets aside enough cash to purchase shares should the option be assigned. This scenario allows the investor to buy shares at a discount should the option be assigned or keep the premium from the expiring option should the assignment not occur.

How to Strategize Using Covered Puts

A covered put is an advanced options trading strategy that won’t be appropriate for less experienced retail investors. Here are a few tips on how to properly use covered puts:

Understand Your Risk Tolerance

Before you start using a covered put strategy, take a moment to consider how much risk you're comfortable with and what your investment goals are. Covered puts mean you sell put options while also owning the stock. It's important to be aware that if the stock price falls significantly, you could face potential losses.

Select the Right Stocks

Pick stocks that you’re okay with holding for a while and that are stable or undervalued. It's best to find stocks with strong fundamentals and sound market positions. This way, if you end up with shares from the sold puts, you'll feel comfortable owning them, and they could appreciate in value later on.

Choose the Right Strike Price and Expiration Date

When selling put options, pick strike prices that match your market view and investment aims. A cautious strategy would be to select a strike price lower than the current market price, offering some protection if the stock drops. Also, take into account the expiration date, based on how long you want to be at risk of the put being exercised.

Monitor Market Conditions and Adjust Accordingly

Keep an eye on market trends and news that could impact the stock. Be prepared to modify your strategy if there's a change in sentiment or major shifts in the company's financial situation. If the stock price is close to the put's strike price as expiration gets closer, you might want to roll the put to a later date or a lower strike price to keep earning premiums.

Regularly Reassess Your Strategy

Regularly assess how well your covered put strategy is working and if it aligns with your overall investment portfolio. Review its compatibility with your investment objectives and determine if the selected stocks are still suitable for the strategy. Make adjustments to your strategy as needed in response to market fluctuations or changes in your personal financial circumstances.

Covered Puts Are a Strategy for Specific Market Conditions

A covered put strategy can create potential profit opportunities in flat markets, but it’s a narrow strategy with limited upside and unlimited downside. When executing a covered put trade, parameters must be tight and entry points well-calculated. Only engage in complex options strategies if you have experience and understand the risks.

Frequently Asked Questions