Let’s dive into the world of options trading, where we can make our money work harder for us. Today’s star? The covered put, a lesser-known but mighty strategy that can help us navigate the turbulent waters of the stock market.
What’s a Covered Put Anyway?
A covered put, also known as a ‘short covered put’, is a financial strategy in the options market. It’s where you short sell the underlying asset and simultaneously sell a put option on the same asset. Sounds a bit like double-dipping, doesn’t it? Well, it sort of is!
In this strategy, you’re taking on an obligation to buy the asset at a specific price (the strike price) before a specific date (the expiration date). Now, this might have you wondering, “Why on earth would I do that?” Let’s break it down.
Playing the Market with a Covered Put
Remember the old saying, “Buy low, sell high?” In a covered put strategy, you’re kind of doing the opposite – you’re selling high and hoping to buy low. Let me explain.
When you initiate a covered put, you’re generally bearish on the market – you think the price of the underlying asset is going to decrease. So, you short sell the asset (sell something you’ve borrowed, planning to buy it back later), hoping the price will drop. At the same time, you sell a put option for this asset. This put option gives someone else the right to sell you the asset at the strike price.
If everything goes as planned, the price of the asset drops, you buy it back at a lower price (thus making a profit on the short sale), and the put option you sold expires worthless because why would anyone want to sell you the asset at a higher price than the market price? In this scenario, you keep the premium from the put option sale as pure profit.
The Nitty-Gritty of a Covered Put Strategy
Let’s put this into a real-world context. Imagine you’re bearish on Stock XYZ, which is currently trading at $50. You short sell 100 shares of Stock XYZ, and at the same time, you sell a put option with a strike price of $45 that expires in a month.
If, after a month, Stock XYZ is trading at $40, you’ve hit the jackpot! You can buy back the shares for $40, making a $10 profit per share on the short sale. The put option you sold will expire worthless because no one wants to sell shares for $45 when they can sell them for $40 in the open market. The premium you received from selling the put option is yours to keep.
The Flip Side of the Coin
Of course, like all strategies in the stock market, the covered put isn’t foolproof. If the stock price goes up, you could face unlimited losses on the short sale (since theoretically, a stock’s price can rise infinitely), while the small premium you received from the put option sale offers little consolation.
The Anatomy of a Covered Put
Let’s delve deeper into the mechanics of a covered put. In this strategy, two transactions are happening concurrently:
- Short selling the underlying asset: This is where you borrow shares from a broker and sell them immediately at the current market price. You’re betting on the price going down so you can buy the shares back at a lower price, return the borrowed shares to your broker, and pocket the difference.
- Selling a put option on the same asset: Selling a put option means you’re giving someone else the right, but not the obligation, to sell the asset to you at a predetermined price (the strike price) before a certain date (the expiration date).
The goal here is to make a profit from the premium you receive when selling the put option and from buying back the shares at a lower price than what you originally sold them for.
Understanding the Risks
While the covered put strategy can be a useful tool when you’re bearish on a particular asset, it’s crucial to understand the risks involved. If the price of the underlying asset goes up instead of down, you could potentially face significant losses.
That’s because there’s technically no limit to how high a stock price can go. If you’ve short-sold a stock at $50, and it goes up to $70, you’ll have to buy it back at that higher price to return the shares you borrowed. This would result in a $20 loss per share. The premium you received from selling the put option can help offset this loss, but only to a limited extent.
Covered Put in Action: Another Example
Let’s say you’re keeping a close eye on Stock ABC, which is currently trading at $100. You believe that over the next two months, the stock’s price is going to go down, so you decide to employ a covered put strategy.
You start by short selling 100 shares of Stock ABC. At the same time, you sell a put option with a strike price of $90, which expires in two months. For selling this put option, you receive a premium of $5 per share.
Fast forward two months. Your prediction was correct, and Stock ABC is now trading at $85. Here’s what your profits look like:
- From short selling: You originally sold the shares for $100 each and now can buy them back for $85. This gives you a profit of $15 per share, or $1500 total.
- From the put option: Because the market price of Stock ABC is below the strike price, the put option is out of the money and expires worthless. Therefore, you get to keep the entire premium of $5 per share, or $500 total.
In total, your profit from this covered put strategy is $2000.
But what if things didn’t go as planned? Let’s say Stock ABC’s price actually went up to $110. In this case, your losses would look like this:
- From short selling: You would need to buy back the shares at the higher price, resulting in a loss of $10 per share, or $1000 total.
- From the put option: The put option would expire worthless, so you would still keep the premium of $500.
So, your net loss in this scenario would be $500.
Remember, this is a simplified example and doesn’t take into account transaction fees or potential changes in the premium price over time. Always consider all potential costs and risks before deciding on a trading strategy.
Covered Put: A Powerful Tool in the Right Hands
A covered put can be a powerful tool in your trading arsenal when used correctly. By understanding the mechanics behind it and the potential risks involved, you can use this strategy to potentially enhance your profits in a bearish market. However, as with all trading strategies, it’s important to do your due diligence and never invest more than you’re willing to lose. Happy trading!
Frequently Asked Questions (FAQs)
How risky are covered puts?
Covered puts carry significant risk, especially because they involve short selling a stock, which has potentially unlimited risk. If the stock’s price rises significantly, losses can mount quickly.
Why would you sell a covered put option?
You might sell a covered put option if you believe a stock’s price will decline. The strategy allows you to earn a premium from selling the put option, and you could also profit if the stock’s price drops and you can buy back the short-sold shares at a lower price.
Is covered put same as selling a put?
No, a covered put involves two transactions: short selling a stock and selling a put option on the same stock. Selling a put alone involves just one transaction.
What is the maximum profit of a covered put?
The maximum profit is the premium received from selling the put, plus the difference between the price at which the stock was short sold and the strike price of the put.
Do you need 100 shares to sell covered puts?
No, you don’t need to own any shares to sell covered puts. Instead, you need to short sell the shares.
Are puts safer than shorts?
Not necessarily. Both strategies can result in significant losses if the stock’s price rises. However, the potential loss from buying a put is limited to the premium paid, while the potential loss from short selling is theoretically unlimited.
When should I buy covered puts?
You don’t buy covered puts; you sell them. You might sell a covered put when you believe a stock’s price will decline.
Is selling a covered put bullish?
No, selling a covered put is a bearish strategy. You’re betting that the stock’s price will decline.
What is the most profitable option strategy?
The most profitable option strategy depends on the specific situation and your market outlook. It’s important to understand the risks and potential rewards of any strategy before using it.
What is a poor man’s covered put?
A “poor man’s covered put” is not a common term in options trading. It might refer to selling a far-out-of-the-money put, which requires less margin but also has a lower probability of profit.
What happens when a covered put is exercised?
If a covered put is exercised, you’re obligated to buy the stock at the strike price. Since you’ve also short sold the stock, you can use those shares to fulfill your obligation.
What is the maximum loss on a sell covered put?
The maximum loss is theoretically unlimited because it depends on how much the stock’s price rises. The higher the price goes, the greater your loss when you buy back the short-sold shares.
How do you make money selling covered options?
You make money by collecting the premium when you sell the option. If the stock’s price goes in the direction you predicted, you could also profit from buying back the short-sold shares at a lower price.
What are the margin requirements for covered puts?
Margin requirements vary by broker, but you’ll generally need enough margin to cover the potential loss from short selling the stock, plus the potential obligation from the sold put.
Can you sell puts with 100 shares?
You can sell a put without owning any shares. If you own 100 shares, you might sell a covered call, not a put.
What are the cons of selling puts?
The main risk of selling puts is that if the stock’s price declines significantly, you could be obligated to buy the stock at a price higher than the current market price.
Can you live off covered calls?
It’s possible, but it depends on many factors, including the size of your portfolio, the premiums you can earn, and your living expenses. It’s also important to remember that covered calls limit your potential upside if the stock’s price rises significantly.
What happens if you sell a put and it expires in the money?
If you sell a put and it expires in the money, you’ll be obligated to buy the stock at the strike price, which will be higher than the current market price.
Can you lose more than you put in with puts?
If you’re buying puts, your potential loss is limited to the premium you paid. If you’re selling puts, your potential loss is the strike price minus the premium received, multiplied by the number of shares (usually 100 per contract).
What is the safest put option strategy?
Buying puts is relatively safe because your potential loss is limited to the premium paid. However, the put could expire worthless if the stock’s price doesn’t decline.
Can you buy a put without owning the stock?
Yes, you can buy a put without owning the stock. This is a bearish strategy that profits if the stock’s price declines.
Is it safer to buy puts or calls?
Both buying puts and buying calls carry risk, and the “safest” strategy depends on your market outlook. Both strategies limit your potential loss to the premium paid.
What happens when you buy a covered put?
You don’t buy covered puts; you sell them. When you sell a covered put, you’re betting that the stock’s price will decline. If the price rises instead, you could face significant losses.
What are the best day to sell puts?
There’s no universally “best” day to sell puts. The best time depends on factors like the stock’s price, volatility, and your market outlook.
Why sell a put instead of buy a call?
Selling a put and buying a call are both bullish strategies, but they have different risk/reward profiles. Selling a put can generate income and potentially obligate you to buy the stock at a lower price, while buying a call gives you the right to buy the stock at a set price.
What is the opposite of a covered put?
The opposite of a covered put might be a covered call, which involves owning a stock and selling a call option. This is a bullish strategy, while a covered put is bearish.
Does selling puts work in a bear market?
Selling puts can be risky in a bear market because the stock’s price could decline significantly, potentially obligating you to buy the stock at a high price.
What option strategy does Warren Buffett use?
Warren Buffett is known for selling put options on stocks he’s willing to own, as well as for using covered calls in certain situations.
Can you become a millionaire trading options?
While it’s possible to make significant profits trading options, it’s also very risky. Most people who trade options lose money. It’s important to understand the risks and to trade only with money you can afford to lose.
What is the easiest option strategy?
Buying calls or puts is probably the simplest option strategy, but it’s still important to understand the risks and potential rewards.
Can you lose money on a covered call?
Yes, you can lose money on a covered call if the stock’s price declines. The premium you collect from selling the call can partially offset this loss.
Why covered calls are bad?
Covered calls aren’t inherently bad, but they do limit your potential upside if the stock’s price rises significantly. They also don’t provide full downside protection if the stock’s price declines.
What is the best delta for a covered call?
The “best” delta depends on your goals and market outlook. A higher delta (around 0.7) could provide more premium but also a higher chance of the call being exercised. A lower delta (around 0.3) might provide less premium but a lower chance of exercise.
Is a married put bullish?
A married put can be a bullish strategy because it involves buying a stock and a put option, which provides downside protection. It allows you to profit if the stock’s price rises, while limiting your potential loss if the price declines.
Should you ever exercise a put option?
It’s usually better to sell a put option before expiration if it’s in the money, because you can often get more by selling the option than by exercising it. However, there might be situations where exercising makes sense.
Can I sell puts if I own the stock?
If you own a stock, you might sell a covered call, not a put. Selling a put is a strategy you might use if you’re willing to buy more of the stock.
Does selling a put have unlimited downside?
Selling a put has significant downside risk, but it’s not unlimited. The maximum loss is the strike price minus the premium received, multiplied by the number of shares (usually 100 per contract).
What is a cash covered put?
A cash-covered put involves selling a put option while also having enough cash in your account to buy the stock at the strike price if the put is exercised. This strategy can generate income and potentially allow you to buy the stock at a lower price.