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What Is A Covered Put Strategy?

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by Gavin in Blog
May 7, 2020 2 comments

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Most retail traders are familiar with buying stocks with the belief that prices will rise and they can sell it in the future for a profit (going long).

What they may not be aware of, is that you can also make a bet on prices falling (going short).

Most retail traders are either purely long or sitting in cash because they are unaware of how to go short or don’t know enough to do it confidently.

Market downturns are a routine part of trading in the markets so at some point prices will fall – it makes sense to know how to go short so that you can profit from the fall and also protect your long positions.

This is particularly important in the lead up to and during severe market corrections, where prices can fall very hard, very fast.

These are some of the best profit opportunities for traders as they can exploit panic selling.

One of the best ways to go short in the market is via options.

Options provide traders with a number of strategies for going long or short as well as strategies for protecting a portfolio.

While there are many ways a trader could use options to go short, this article will focus on the covered put strategy.

We’ll run through what it is and how to use it in your trading.

What Is A Covered Put? 

Before we discuss the covered put, let’s recap what a standard put is.

Recall that options give us the right, but not the obligation, to buy/sell an underlying security at the strike price and before the expiration date.

In the case of a put, the option holder has the right, but not the obligation, to sell the underlying security at the strike price, up until the expiration date.

So if a trader believes a particular stock will fall in price, it can be used as a straightforward way to go short.

There will be times however, where a trader may believe that while a drop in stock price will occur, there will be a period of time where the price may remain stable.

This is when a covered put strategy could be deployed.

Say for example that a trader has an existing short position in a stock, believing it will be some time before the stock will actually start to fall in price.

The trader could close off the position and attempt to re-open it later, but may feel it would be too risky to try and time when the sell-off will begin.

 

 

By using a covered put strategy, the trader keeps their original short position open and uses the covered put to generate profits from the premium received for writing the put.

While this will limit the maximum gain on the existing short position, it does allow for some low protection from price increases.

How Do You Execute A Covered Put Strategy? 

To execute a covered put strategy you will need to write enough puts to cover any stock you have sold short.

There are two key decisions involved, namely what you want the strike price to be and what you want the expiration date to be.

Choosing the expiration date is relatively simple.

All that’s required is to estimate how long you think the price of the stock will remain stable and then to set an expiration date that reflects that.

So the longer the estimated price stability, the further out the expiration date should be.

Setting the strike price relies on a bit of judgement, but generally speaking you would set the strike price so that the option is either at the money or just out of the money.

While you could always go lower, it will mean those contracts are cheaper and you will receive a smaller credit.

That might not be a bad thing depending on your existing position and belief about the future price action.

The next section will help you to understand the implications of having a smaller credit.

What is My Profit and Loss Potential? 

Let’s work through an example.

Say you were short company ABC, with a position size of 200 shares at a current trading price of $40.

Since each options contract contains 100 options, you would need to write two put contracts in order to execute a covered put strategy.

You decide to set a strike price that is just out of the money at $39.

You believe there’s a few weeks of price stability ahead, so you set the option to expire at the end of the following month.

This provides you with a net credit of $300, assuming $1.50 per option.

Note that you could also trade a poor man’s covered put, which uses the same login as the poor man’s covered call.

The maximum profit potential is for the price of the stock to drop and match the price of the option.

That is to say, the stock price drops to $39.

In this scenario, you would receive $1 profit per share you’ve shorted, so $200, and at the same time the put options have expired at the money and are therefore worthless.

Your total profit is therefore $500 ($200 short + $300 net credit from writing the put).

Considering another scenario, if the price were to drop further than $39, the put options would move into the money.

This means that some of the profit from your short stock position would be offset by losses on the put option.

The final and worst scenario is that you were wrong about the price of the stock falling and instead it goes up.

In this scenario, your short stock position will be at a loss, but it will be partially offset by the credit from your covered put.

However, if the price of the stock goes up drastically, even the credit from your covered put may not be enough to offset your losses.

This is why selecting the strike price is very important.

The lower it is, the less credit you will receive and the less you will have to offset any losses and supplement any gains.

Conclusion 

The covered put strategy allows traders to profit from being bearish on a stock that may experience a period of stability.

It is executed by writing enough put option to cover the amount of stock being shorted, at a strike price that is generally at the money or just out of the money.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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2 Comments
  1. Bubba says:

    How about an article on a Poor Man’s Covered Put???

    1. Gavin says:

      Good idea. Poor man’s covered call is done. Poor man’s covered put is the same just the bearish version.

      https://optionstradingiq.com/poor-mans-covered-call/

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