Covered Put Explained

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Covered Put

Writing covered puts is a bearish options trading strategy involving the writing of put options while shorting the obligated shares of the underlying stock.

Covered Put Construction
Short 100 Shares
Sell 1 ATM Put

Limited profits with no downside risk

Profit for the covered put option strategy is limited and maximum gain is equal to the premiums received for the options sold.

The formula for calculating maximum profit is given below:

  • Max Profit = Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying

Unlimited upside risk

As the writer is short on the stock, he is subjected to much risk if the price of the underlying stock rises dramatically. In theory, maximum loss for the covered put options strategy is unlimited since there is no limit to how high the stock price can be at expiration. If applicable, the covered put writer will also have to payout any dividends.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying >= Sale Price of Underlying + Premium Received
  • Loss = Price of Underlying – Sale Price of Underlying – Premium Received + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the covered put position can be calculated using the following formula.

  • Breakeven Point = Sale Price of Underlying + Premium Received

Example

Suppose XYZ stock is trading at $45 in June. An options trader writes a covered put by selling a JUL 45 put for $200 while shorting 100 shares of XYZ stock. The net credit taken to enter the position is $200, which is also his maximum possible profit.

On expiration in July, XYZ stock is still trading at $45. The JUL 45 put expires worthless while the trader covers his short position with no loss. In the end, he gets to keep the entire credit taken as profit.

If instead XYZ stock drops to $40 on expiration, the short put will expire in the money and is worth $500 but this loss is offset by the $500 gain in the short stock position. Thus, the profit is still the initial credit of $200 taken on entering the trade.

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However, should the stock rally to $55 on expiration, a significant loss results. At this price, the short stock position taken when XYZ stock was trading at $45 suffers a $1000 loss. Subtracting the initial credit of $200 taken, the resulting loss is $800.

Note: While we have covered the use of this strategy with reference to stock options, the covered put is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Naked Call Writing

An alternative but similar strategy to writing covered puts is to write naked calls. Naked call writing has the same profit potential as the covered put write but is executed using call options instead.

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Manage Risk with Covered Calls and Covered Puts

While some options strategies can be risky, covered calls and covered puts can help you potentially increase profits and limit losses.

It’s a common misunderstanding that all options trading strategies are risky, complicated, and suitable only for speculators. While this is true for some options strategies, many strategies—such as covered calls and covered puts—can be used to hedge and help minimize the risks of trading. In fact, when employed correctly, covered calls and covered puts can potentially increase profits and limit losses simultaneously. Let’s find out how.

Covered calls: Long stock position and short calls in equal quantity

Covered calls, one of the most common and popular option strategies, can be a great way to generate income in a flat or mildly uptrending market. A covered call is when you own the underlying stock and then sell someone the right to buy the stock if the strike price is reached before expiration.

Covered calls also offer limited risk protection. The protection is confined to the amount of premium received, but this can sometimes be enough to offset modest price swings in the underlying equity.

A covered call writer typically has a neutral to slightly bullish sentiment. In many cases, the best time to sell covered calls is either when establishing a long equity position (buy/write), or once the equity position has already begun to move in your favor.

When creating a covered call position, it is generally best to sell options with a strike price equal to or greater than the price you paid for the equity. If you sell out-of-the-money calls and the stock remains flat, declines in value or even increases a little, the calls will likely expire worthless and you’ll get to keep the premium you received when you sold them, with no further obligation. If you sell at-the-money calls, and the stock declines in value, the options will expire worthless with essentially the same result. Once that happens, you can do it all over again for another month.

If the stock appreciates in value to slightly above the strike price, you’ll probably have your stock called away at the strike price, either prior to or at expiration. This is not a bad thing. If you sold at-the-money or out-of-the-money calls, the trade will generally be profitable, and the profit will usually exceed what you would have made by buying the stock and selling it at the appreciated price.

Here’s a hypothetical example of a covered call trade. Let’s assume you:

  • Buy 1,000 shares of XYZ stock @ 72
  • Sell 10 XYZ Apr 75 calls @ 2

Because you bring in two points for the covered call, it provides two points of immediate downside protection. In other words, you will not have a loss unless the stock drops below $70.

But there’s always a downside, and in this example the trade-off is that you limit the upside profit potential beyond a price of $77. So you would only want to do this if you think the price of XYZ will not exceed $77 by the April expiration. If XYZ does increase above $77, the stock purchase alone would have been more profitable.

Look at the profit and loss chart below. Notice that:

  • The breakeven price is $70.
  • The profit is capped at $5,000 for all prices above $75, i.e.:
  • $3 x 1,000[shares stock] + $2 x 10[options contracts] x 100[options multiplier]
  • The stock can drop two points before you go into the red. Losses will be incurred below $70 to zero.
  • Losses could be as much as $70,000 if the stock price drops to zero, but they will always be $2,000 less than the stock trade alone.

Note: Chart depicts strategy at expiration.

Covered puts: Short stock, short puts in equal quantity

Covered puts work essentially the same way as covered calls, except that the underlying equity position is a short instead of a long stock position, and the option sold is a put rather than a call.

A covered put writer typically has a neutral to slightly bearish sentiment. Selling covered puts against a short equity position creates an obligation to buy the stock back at the strike price of the put option.

Just like with covered calls, the best time to sell covered puts can be either at the same time a short equity position is established (sell/write), or once the short equity position has already begun to move in your favor.

Here’s a hypothetical example of a covered put trade. Let’s assume you:

  • Sell short 1000 shares of XYZ @ 72
  • Sell 10 XYZ Apr 70 puts @ 2

Take a look at the profit and loss chart below. Notice that:

  • The breakeven price is $74.
  • The profit is capped at $4,000 for all prices below 70, i.e.:
  • $2 x 1,000[shares stock] + $2 x 10[options contracts] x 100[options multiplier]
  • Even though there are two points of price protection against an increase in the stock price, losses will be incurred above $74.
  • Losses could be unlimited if the stock price continues to increase, but they will always be $2,000 less than the stock trade alone.

You would want to employ this strategy only if you think the price of XYZ will not fall below $70 by the April expiration. If XYZ does fall below $70, the short stock trade alone would be more profitable.

Note: Chart depicts strategy at expiration.

Be careful

While covered calls and covered puts limit risk somewhat, they cannot eliminate it entirely. With that in mind, here are a few cautionary points about these strategies:

  • Profits. Covered options usually prevent significant profit potential if a stock moves substantially in your favor. Anytime you sell a covered option, you have established a minimum buying price (covered put) or maximum selling price (covered call) for your stock. Any stock movement beyond that established price creates no additional profit for you.
  • Losses. Losses are limited only by the amount of premium you received on the initial sale of the option. In addition, it is rarely a good idea to sell a covered option if your stock position has already moved significantly against you. Doing so could cause you to establish a closing price that ensures a loss. So before you sell, ask yourself, “Would I be happy if I had to close out my stock position at the strike price on this option?” If you can answer “yes,” you will probably be OK.
  • Holding until expiration. While our examples assume that you hold the covered position until expiration, you can usually close out a covered option at any time by buying it to close at the current market price. Regardless of whether the equity part of your strategy is profitable or not, waiting until expiration will maximize your return on an out-of-the-money option; however, you are not required to do so.
  • Assignment. A significant change in the price of the underlying stock prior to expiration could result in an early assignment, and if your short option is in-the-money, you could be assigned at any time. Covered calls written against dividend paying stocks are especially vulnerable to early assignment.
  • Corporate events. When companies merge, spin off, split, pay special dividends, etc., their options can become very complicated. The StreetSmart Edge® trading platform has detailed information regarding the terms of adjusted options; please review it carefully before you trade them.

What is a covered put?

From time to time, someone will ask me, “What is a covered put?”. I pause as I know that the following conversation pertains to a little used and often misunderstood strategy. A strategy that has a potentially unlimited risk. A strategy that can be used with a bearish outlook and one that can be structured with some minor adjustments to significantly reduce the risk.

Before I start to describe the covered put, I’d like to remind you that options provide an almost unlimited number of possible configurations. With many expirations, numerous strikes, calls versus puts and shorts versus longs, the only limit on what can be done with options is your understanding and your imagination.

So, what then is a covered put? It is a position where the investor shorts the underlying and then sells a put (one short put for each 100 shares of the equity).

What a covered put is not: There is some confusion with the terminology used in the world of options trading. A covered put is not a “cash-secured short (naked) put”. I have come across articles that treated a covered put (other terminology used to describe this strategy: covered put options strategy, covered put writing, covered put option) as if it were a cash-secured naked put.

It is not uncommon for an investor to use a naked put as an income generating strategy. The execution of the strategy simply has the investor selling a put option (typically) below the current price of the underlying. They receive a credit for the sale of the put. If the price of the equity remains at or above the strike price of the sold put option through expiration, the investor keeps the premium received initially. If the equity falls in price and is below the strike price of the option at expiration (or if assigned early as an American style option can be), then the investor would be obligated to buy the equity itself for a dollar value that is equal to the strike price of the sold put. Using this strategy, one typically has enough cash reserved in case this situation does occur. The logic of the strategy is based in the view that equity ownership at this price point (the strike of the short put) is desirable. I have my own thoughts on that, but I’ll save that for another blog…

The most significant difference between a covered put and a cash-secured (or not) naked put is the risk. Take a look at the two profit and loss graphs below. The first is the covered put. Notice that the directional bias is stagnant to bearish. Because the short put obligates the seller of the put to buy the stock at the strike price of the put, thus flattening the short stock position, the return is limited. This limited return is the difference between the proceeds received from shorting both the stock and the put, and the strike price of the put.

If the stock becomes bullish, the short stock position becomes very risky as the short stock seller will have to buy the stock at a higher price than they sold it for. Since there is no theoretical limit to how high a stocks’ price could go, the risk is also theoretically unlimited. The sale of the put does offer a slight increase in the break-even price for the equity. That increase is limited to the cash received for the sold put itself. Therefore the theoretical break-even point can be calculated by adding the sale price of the stock to the premium received for the sale of the put. The risk is still infinite. We’ll discuss limiting the risk a bit later on…

A short (or naked) call has the same risk profile and some would consider them to be synthetically equal.

Unlike the covered put, the naked call has lower transaction costs. A covered put has the additional fees to short the stock and eventually buy back the stock to close the trade. The naked call only has the opening transaction fees.

A naked (or cash secured) put on the other hand offers limited risk since the stocks’ price can only fall to zero. Take a look at the profit and loss graph below. The maximum return of the naked put is the premium received. To achieve this, the underlying equity simply needs to remain at or above the strike price of the short put. That implies that the equity can be bullish, stagnant or even slightly bearish and the writer of the put will make money. The risk is the strike price of the put minus what you were paid to sell the put. This is also the breakeven point for this trade, the strike of the short put minus the credit received. The risk is realized when the equity’s price falls below the strike price of the short put.

Both of the above strategies involve the sale of a put. The covered put also includes the short sale of the underlying equity. Both trades offer limited returns. The covered put has unlimited risk whereas the naked put does not.

I mentioned earlier that there are ways to limit the risk of the covered put. A very simple approach would be to add a long call (one contract for each 100 shares of short stock). You would determine what amount of risk you are willing to take on the entire trade and then buy a call at a strike price that would cap your risk at that dollar value. How would this work? Let’s say that you do not wish to risk more than $2,000 on the trade. Divide that by 100 and then divide that by the number of contracts that you are considering for the trade. If you were planning on selling 200 shares and shorting 2 put contracts, the strike of the long call could be determined by the following example: (2000/100)/2 = 10. The long call would be purchased at a strike price that is $10 greater than the current price of the stock. This would add debit to the trade but it would also limit the amount of risk exposure that your portfolio would have. Take a look at the profit and loss graph below. It shows that by adding a long call to the covered put, you have limited the amount of loss that you could experience in the trade:

In summary, the covered put is a strategy meant to take advantage of a bearish trend. It has limited reward and unlimited risk (at least theoretically). In many ways, it is similar to a naked call in that they both have limited return and unlimited risk. The cash secured naked put seems to be a superior position in that it does not involve shorting the stock (something most retail traders are uncomfortable doing). Additionally, the unlimited risk of the covered put (as well as the naked call) compared to the limited risk of the naked put is another argument for one over the other.

As was pointed out, the risk element of the covered put can be reduced dramatically by buying long calls. In that way, the risk can be determined and controlled by the selection of which strike price to buy.

The covered put is just one of the nearly infinite trades available. What trade you choose to place must be a reflection of your expectations. At OptionsANIMAL we believe that expectation must come first and then the trader must match that expectation with the appropriate financial instruments. Additionally, we never enter a trade without first developing our plans for the original trade to go wrong. Remember, failing to plan is planning to fail…

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