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How Does The Covered Put Work in Options Trading?

Covered Put Risk Graph
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Covered Put - Introduction

The Covered Put, also known as Selling Covered Puts, is a lesser known variant of the popular Covered Call option strategy. In a Covered Call, you buy shares and sell call options against it in order to profit from a stagnant or bullish move while in a Covered Put, you short shares and then sell put options against it in order to profit from a stagnant or bearish move.

Studying the Covered Call first makes the Covered Put easier to understand.

Selling Put options in this case is considered "Covered" due to the short shares. If the short put options are assigned, shares will be delivered which will covers the short share position.

Find Options Strategies With Similar Risk Profiles

The Covered Put is not a common strategy that most option traders use when speculating a stagnant or bearish move in the underlying stock as a Covered Put has a limited profit potential along with an unlimited loss potential. Couple this with the fact that most shares rise over time, the Covered Put is always exposed to the danger of unlimited loss. When speculating a quick bearish move on the underlying stock, most option traders prefer to use other complex bearish strategies which profits from both a bearish and stagnant move on the underlying move like the Bear Ratio Spread.

A Covered Put is most commonly used by share traders to increase the profits from shorting shares and also to protect a short share position against a slight rise in price. In the first scenario, if the underlying stock should drop to the strike price of the put options sold, one would make the drop in price on the underlying stock plus the premium on the put options sold as profit. In this case, the premium on the put options sold serves as additional profits. In the second scenario, the premium on the put options serves to offset the loss on the short shares should the underlying stock rise.

When To Use Covered Put?

One should use a Covered Put when one wishes to increase one's profits when shorting shares or to protect one's short share position from a slight rise in price.

How To Use Covered Put?

Establishing a Covered Put is extremely simple. All you have to do is to write (sell to open) 1 contract of nearest out of the money put option for every 100 shares you shorted.

Covered Put Example

Assuming you shorted 700 shares of QQQQ at $44. Sell To Open 7 contracts of QQQQ Jan43Put.

Profit Potential of Covered Put :

The Covered Put's maximum profit occurs when the stock closes exactly at the strike price of the short put options at expiration.

Covered Put Example

From the above example : Assuming your 700 QQQQ close at $43 upon expiration of the 7 contracts of QQQQ Jan43Put. You will make the $1 move in QQQQ plus the value of the 7 Jan43Put that you wrote as profit.

Such an ideal situation is, of course, rare. In most cases, the short put options will either be in the money or out of the money at expiration.

When the underlying stock is stagnant or slightly lower upon expiration of the short put options, you will profit on the whole value of the put options that you wrote, with whatever profit from the stock.

Covered Put Example

From the above example : Assuming your 700 short QQQQ close at $43.50 upon expiration of the 7 contracts of QQQQ Jan43Put. You will make $0.50 from the QQQQ move plus the whole value of the 7 Jan43Put.

When the underlying stock drops below the strike price of the short puts options upon expiration, further gain in value on the short shares will be offset by an equivalent rise in value on the put options that you sold. This means that if the underlying stock drops below the strike price of the short put options, the position will stop rising in value.

Covered Put Example

From the above example : Assuming your 700 QQQQ close at $42 upon expiration of the 7 contracts of QQQQ Jan43Put. You will gain $2 from the short shares, $1 from the short put option's premium value and lose $1 on the short Jan43Puts as it goes $1 In The Money for a net gain of $2.

Profit Calculation of Covered Put:

Maximum profit = (Short Stock Price - Strike Price) + Option Bid

Covered Put Calculations

Assuming you bought 700 QQQQ close at $44 and sold 7 contracts of QQQQ Jan43Put @ $1.00.

Maximum Profit = ($44 - $43) + $1.00 = $2.00

Risk / Reward of Covered Put:

Maximum Profit: Limited

Maximum Loss: Unlimited

Break Even Point of Covered Put:

Breakeven point for Covered Puts is the point where the position will start losing money if the underlying stock rises instead of fall.

Break Even = Short Stock Price + Option Bid

Following up from the above example : $44 + $1.00 = $45.00

Advantages Of Covered Put:

Able to profit even if your stock stays stagnant.

Able to offset losses if your stock rises instead of falls.

No margin required for writing put options.

Disadvantages Of Covered Put:

You must continue to hold your short stocks if you want to keep the short put options.

Your broker must allow you to short stocks in the first place.

Adjustments for Covered Puts Before Expiration :

1. If you expect the underlying stock to fall drastically, you should buy to close the short put options.

Questions on Covered Put

:: "Difference Between Selling Put and Covered Put?"

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Covered Put