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:
When to consider this strategy
A covered put trade is a short-term trading technique because the option writer expects range-bound trading in the underlying stock. Long-dated options aren’t advised because volatile stock swings can be a negative for this strategy.
Execution Process
When writing a covered put, the goal is for the option to be assigned near the strike price. This allows the writer to keep their option premium while repurchasing shares at a lower price than the initial short position.
Maximum Gains
Gains are somewhat limited when using covered puts, which is why it’s ideal for range-bound or market-neutral trading. The maximum gain formula goes like this:
- Maximum gain = Price at short sale - option strike price + option premium
Maximum Losses
Since a short position is initiated at the start of the trade, the maximum loss is unlimited. However, the premium from the option helps to cushion some downside risk. For example, if the stock price rises quickly, the losses from the short position can be unlimited, but the put option will expire worthless, allowing the writer to keep the premium.
Breakeven Point
A covered put trade will break even if immediate assignment occurs at intrinsic value. In this scenario, breakeven equals the price of the shorted stock plus the premium received from the option.
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
How does selling a covered put work?
Selling a covered put means you write a put option for a stock you’ve already sold short. The premium received from selling the put option helps to provide small cushion against potential losses from the short position.
Is it better to sell covered calls or puts?
It depends on the market trend and thesis of the investor. For example, covered calls are typically considered when the investor has a slightly bullish opinion of the stock; covered puts are typically considered when the investor’s sentiment is somewhat bearish.
How do you lose money on a covered put?
A covered put strategy will lose money if the underlying stock price increases rapidly before the put option expires.
About Dan Schmidt
Dan Schmidt is a finance writer passionate about helping readers understand how assets and markets work. He has over six years of writing experience, focused on stocks. His work has been published by Vanguard, Capital One, PenFed Credit Union, MarketBeat, and Fora Financial. Dan lives in Bucks County, PA with his wife and enjoys summers at Citizens Bank Park cheering on the Phillies.