When you have a short position on a stock, a covered put strategy can help you generate income and manage risk. By selling covered put options, you can earn premiums to reduce your short position’s cost basis. This article explains what a covered put is and offers a covered put example to handle risk effectively. Let’s begin: what is a covered put? And what is the best way to use it?
Key takeaways
- The covered put strategy is a technique that combines holding a short stock position with selling a put option, allowing investors to generate income while managing risk in a moderately bearish market.
- By selling put options, traders can earn premiums, which may reduce the overall cost basis of their short stock position, enhancing potential returns.
- The main risk of this strategy is unlimited downside if the stock price increases. However, traders can adjust and roll their positions to better manage risk in changing market conditions.
What Is a Covered Put? [Covered Puts Explained]
What is a covered put? While this is likely a less popular strategy compared to the covered call, it can be highly effective in certain scenarios. Here’s what you need to know about the covered put strategy:
Definition and Components – Sell Covered Puts Explained
A covered put combines a short stock position with selling a put option. This strategy involves having a short position in a stock and then selling a put option on the same stock.
- Short Stock Position: The investor borrows shares of the stock and sells them at the current market price, hoping to buy them back later at a lower price.
- Selling a Put Option: The investor sells a put option, giving the buyer the right to sell the stock to the investor at a specific price (strike price) before a certain date (expiration date).
Use Cases
- When and Why to Use: Investors typically use covered put options when they have a moderately bearish outlook on a stock. This strategy allows them to generate income through the premiums received from selling the put options, which can offset some of the risk and costs associated with holding a short stock position.
- Suitability for Moderately Bearish Outlooks: The covered put strategy is suitable for investors who believe the stock price will decrease slightly or remain flat. It is not ideal for extremely bearish scenarios because the potential profit is limited to the premium received from the put options.
Mechanics – How It Works
- Entering the Position: To enter a covered put position, an investor must first short at least 100 shares of the stock (for each put option sold). After establishing the short position, the investor sells a put option.
- Example: Suppose an investor shorts 100 shares of XYZ stock at $50 per share. They then sell a put option with a $45 strike price for a premium of $2 per share. If the stock price remains above $45 until expiration, the put option expires worthless, and the investor keeps the premium.
Specifically, here is the typical profit and loss (P&L) profile you’ll find on an options screener if you wish to sell covered puts:
Outcome Scenarios
- Stock Price Falls Below Strike Price: If the stock price falls below the strike price, the investor must buy the stock at the strike price, which covers their short position. The profit is the difference between the short sale price and the strike price, plus the premium received.
- Stock Price Remains Above Strike Price: If the stock price stays above the strike price, the put option expires worthless, and the investor keeps the premium while maintaining the short position.
Risk Profile
One of the significant risks of the covered put strategy is the unlimited downside risk if the stock price increases. Since the investor holds a short stock position, any rise in the stock price can lead to substantial losses. The premium received from selling the put option only partially offsets this risk. Here is how you can manage your risk:
- Rolling Options: Investors can manage risk by rolling put options to different expiration dates or strike prices based on market conditions.
- Adjusting Positions: Investors can also adjust their positions by buying back the put options if they anticipate adverse movements in the stock price.
Real-Life Covered Put Example
As always, an example will clarify the covered put strategy in action. Let’s consider Apple (AAPL). Say you think AAPL’s price has gone up too much over the past few weeks, and you feel there’s a good short opportunity here. In this case, you could short 100 shares of AAPL at the current price of $226.05 and sell an in-the-money (ITM) put with a $235 strike price expiring in two weeks.
So, here is what you would do:
- Stock Shorted: 100 shares of AAPL at $226.05
- Put Option Sold: $235 strike price, expiring in two weeks
This covered put example setup results in a breakeven point of $237.68. How do you compute it? You simply start from your short price and add the premium received from the put you sold. In our specific case, we have $226.05 + $11.63, which gives $237.68.
Here is what your P&L profile will look like if you decided to sell covered puts on AAPL in the way described above (we’ll comment on it below):
Note that, in percentage terms, your breakeven point is 5.1% away from the current price of the stock.
Potential Outcomes
- Stock Price Below Strike Price at Expiration: If AAPL’s price is below $235 at expiration, you keep the premium received from selling the put. As you can see from the P&L chart above, your maximum profit would be $200 (roughly equal to 0.9% of the trade).
- Stock Price Above Strike Price at Expiration: If AAPL’s price rises above your breakeven point of $237.68, your losses start to accumulate. Your losses are theoretically unlimited as the stock price can rise indefinitely. Note that the premium of your option will mitigate your losses in the worst-case scenario, but it will not cap them.
Covered Put Strategy Suitability
You might argue that using a covered put strategy on a stock like Apple, known for its strong performance, is risky. This is a valid concern, and choosing a company with weaker fundamentals might be safer. Alternatively, you could also explore the covered call strategy, which can be more suitable for moderately bullish outlooks.
Alternative Strategies
If you’re looking for alternative strategies, consider:
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- Selling calls: In practical terms, the strategy works pretty much like the covered put one.
- Buying puts: If you want to cap your risk, you could choose to buy puts on a stock you expect to decline.
And if your outlook on the underlying stock changes, you could consider alternative strategies. If you suddenly turn bullish, for instance, you could evaluate selling cash-secured puts or buying calls on the same underlying stock.
Advantages and Disadvantages of Covered Put Options
There are some clear pros and cons that you could easily spot from our covered put example on AAPL. Let us summarize them in the table below:
Advantages
- Income Generation Through Premium Received: One of the main benefits of the covered put strategy is the ability to generate income. By selling covered put options, investors receive premiums from buyers. This immediate income can offset some of the risks associated with holding a short stock position.
- Reduction of Cost Basis on the Short Stock Position: Each premium received from selling a put option reduces the overall cost basis of the short position. This means that the break-even point for the investment is lowered, making it easier to achieve profitability even if the stock doesn’t move as expected. For example, if you short 100 shares of a stock at $100 and sell a put option for $5, your new cost basis becomes $95.
- Suitable for Moderately Bearish Outlook: The covered put strategy is particularly effective in a moderately bearish market. It allows investors to profit from small declines or stagnant prices of the underlying stock. From this point of view, the covered put strategy provides a way to monetize a bearish outlook without needing significant price drops to realize gains.
Disadvantages
- Unlimited Downside Risk if Stock Price Increases: One of the most significant downsides of the covered put strategy is the unlimited risk if the stock price increases. Because the investor holds a short stock position, any upward movement in the stock can lead to substantial losses. For instance, if the stock price rises significantly, the losses from the short position might far exceed the income from the sold puts.
- Requires a Margin Account and Sufficient Capital: Implementing a covered put strategy requires a margin account, which isn’t available to all investors. Additionally, maintaining sufficient capital to cover potential losses is crucial. The need for a margin account can also mean higher transaction costs and interest charges, especially if the borrowed shares are heavily shorted.
- Limited Profit vs Unlimited Risk: The unlimited downside risk mentioned above comes with capped profits, which may make the trade not worth it for certain investors.
Adjusting (Rolling) a Covered Put
No matter how good your strategy, sometimes you will find yourself needing adjustments. This does not mean that you did not understand how to use the covered put strategy; it simply means that the strategy cannot work every time the way you wanted.
The good thing is there are ways to adjust your covered put strategy as the underlying stock’s price changes. Here’s a summary table on how you can roll a covered put:
Adjustments
If the stock price moves significantly, you may need to adjust your covered put position. For example, if the stock price rises and your short put option is likely to expire worthless, you can roll it to a higher strike price or further out in time to collect more premium. Conversely, if the stock price falls and puts your short put option in-the-money, you might consider rolling it down to a lower strike price to avoid being assigned. Another way to handle such scenarios is by opening a different trade, like the bull call spread strategy, which offers a different risk management approach.
Rolling
Rolling involves closing your existing put option and opening a new one with a different expiration date or strike price. This can help manage risk and optimize potential profits. When should you roll your position? Let us simplify the matter as follows:
- Stock Price Rising: If the stock price rises, rolling the put to a higher strike price within the same expiration month or to a later month can bring in an additional premium.
- Stock Price Falling: If the stock price falls and the put option goes in-the-money, rolling down to a lower strike price can prevent assignment and manage downside risk.
Scenarios Where Rolling is Beneficial
- Maintaining Income: By rolling to a new expiration date or strike price, you continue to generate income through premiums.
- Avoiding Assignment: Rolling can help prevent being assigned the stock, especially if you do not want to close your short position.
How Do Time Decay, Implied Volatility and Other Factors Affect the Covered Put Strategy?
A point we want to address before leaving you is how time decay, implied volatility, and other factors affect the covered put strategy.
Interest Rate
An aspect you should not disregard is that, since a covered put will give you cash from the short stocks and the option you sold, you could earn an interest rate on the cash in your account. Some brokers will pay over 4% on the cash in your account.
Time Decay
Time decay, or theta, refers to the reduction in the value of an options contract as it approaches its expiration date.
For the covered put strategy, time decay is beneficial. The value of the short put option decreases over time, allowing investors to potentially buy back the option at a lower price than what they sold it for, thereby capturing the premium as profit.
Implied Volatility
Implied volatility (IV) measures the market’s forecast of a stock’s price movement. Higher IV means higher option premiums because there’s an expectation of more significant price swings.
Always keep in mind this aspect: you want IV to be high before entering the trade (because it will mean you are short-selling an overbought option). As time passes, you’ll want IV to move down, which will have a negative impact on the price of the option you sold.
