Covered Put Strategy
The covered put is a trading strategy that uses options to try and profit if a stock that has been short sold doesn't drop in price. A trader will short sell stock if they expect a drop in the share price, but there may be periods when they think the share price is likely to stay stable for a period of time i.e. they have a neutral outlook.
Because their short position won't return any profits if there is no price drop, alternative actions are required to try and make some money. This is where the covered put comes in; it involves writing put options with the expectation that they will expire worthless and provide some profit. We should point out that this in't a commonly used strategy, and it's one that should only be considered in very precise circumstances. We have provided more information on it below.
The Key Points
- Neutral Strategy
- Not Suitable for Beginners
- One Transaction (write puts)
Why Use a Covered Put?
The covered put is classed as a neutral strategy, because its main purpose is to try and profit from a stock that doesn't move in price over a period of time. It would be used if you have an open short stock position and you believe that the price of the relevant stock is about to go through a period of stability and not likely to move.
You could simply close your position, but if you wanted to keep it open in the belief it will go down in the long run, then the covered put offers a way to potentially make a return during the period of stability. It will also offer you some low level protection if the price of the short sold stock went up unexpectedly.
Implementing the Covered Put
Implementing the covered put is a very straightforward process. All you have to do is write enough puts (using the sell to open order) to cover the amount of stock that you have short sold. You will need to make two specific decisions, and they are what expiration date to use and what strike to use.
These decisions ultimately depend on what your expectations are and what you are trying to achieve. You should use the expiration date that is appropriate for how long you think the stock will remain stable for. If you think it will be stable for a prolonged period of time, then you should write contracts with a long term expiration date. If you think it will be stable only for a short period, then a shorter term expiration date is appropriate.
In terms of the strike, we would generally recommend that you write contracts that are at the money or just out of the money. You can use a lower strike if you wish, but you will receive less of a credit and those contracts will be cheaper. Below we have provided an example of when, and how, you might use a covered put.
- You have short sold 100 shares of Company X stock, which is currently trading at $50. We shall refer to this price as the Starting Point.
- You believe that the price stock will remain relatively stable for a short period of time, and you want to try and profit from that stability.
- You write 1 contract of put options (each contract contains 100 options) that are out of the money ($49 strike) and expire at the end of the following month for a net credit of $150 ($1.50 per option).
Potential Profits and Losses
The ideal scenario for you is that the price of the stock drops from $50 to $49. This will give you a $1 profit per share that you have short sold, and also mean that the puts you have written will expire at the money and worthless. The net credit of $150 you received for writing those will a total profit of $250.
This is the most you will be able to profit though, because if the price goes any lower then any additional profit you make from the original position will be offset by the put options that you have written. If it falls below $49, the puts will move into the money and could be assigned, which would force you to buy the stock at the $49 strike. You would also make a profit if the price stayed at exactly $50, or dropped to somewhere between $49 and $50. The puts would expire worthless, profiting you the $150 credit.
The biggest risk is that the price could increase by a significant amount. If this happens, your short stock position will start to lose you money. Any losses will be offset by the $150 credit received for writing the puts (these will expire worthless any time the share price is above $49, but if the share price went up dramatically that would only cover a fraction of your losses. The potential profits and losses can be summarized as follows.
- Maximum profit is made when “Price of Underlying Stock = Strike of Options”
- Profit is also made when “Price of Underlying Stock > or = Starting Point but < Strike of Options”
- Profit, per share short sold, is “(Starting Point – Price of Underlying Security) + Price per Option”
- This profit calculation does not apply if “Price of Underlying Stock < Strike of Options”.
- Profit, per share short sold, when “Price of Underlying Stock < Strike of Options” is “(Starting Point – Strike of Options) + Price Per Option”
- Break-even point is “Price of Underlying Stock = Starting Point + Price of Option”
- Losses are unlimited when the underlying stock moves above the break-even point.
- Losses, per share short sold, are “Price of Underlying Stock – (Starting Point + Price of Option)”
It has been suggested by some that profits made from a fall in the price of the stock, or losses made from a rise in the price, should't be included because those profits or losses will be made from the original position whether a covered put is used or not. However, we have included them so that the calculations are accurate for the whole position. The calculations do not, however, take into account any profits or losses made on the original position prior to applying the covered put. They also don't take into account commission costs.
The covered put can be an effective way to profit from a short stock position when the share price is stable for a period of time. However, it does limit your potential profits should the share price fall and it only offers very limited protection should it increase. As such, this is a trading strategy that should only be considered if you are very confident that the share price will be relatively neutral for the relevant period of time.