Covered puts are a popular options trading strategy that involves selling a put option while simultaneously shorting the underlying stock. This strategy aims to generate income from the premium received for selling the put option, while the short position provides a hedge against potential losses. In this article, we’ll explore the concept of covered puts, their benefits, and when to use them in your trading strategy.
What are Covered Puts?
Definition of a Covered Put
A covered put is an options trading strategy where an investor sells a put option while simultaneously shorting an equivalent number of shares of the underlying stock. This is done to collect premium income from the sale of the put option while mitigating potential losses from the short position.
How Covered Puts Work
When you execute a covered put, you sell a put option and short the underlying stock at the same time. By doing so, you’re hoping that the stock price will decrease, allowing you to buy back the shares at a lower price and profit from the difference. If the stock price increases, the put option will expire worthless, and you’ll still profit from the premium received from selling the option.
Why Trade Covered Puts?
Income Generation
Covered puts can be a valuable source of income for investors, as the sale of the put option generates premium income. This income can help offset the costs of shorting the stock or enhance overall returns.
Hedging
The primary benefit of a covered put is the hedge it provides against potential losses from shorting the stock. If the stock price increases, the put option acts as insurance, limiting the investor’s downside risk.
When to Use Covered Puts
Bearish Market Outlook
Covered puts are most effective when an investor has a bearish outlook on the underlying stock. If you believe the stock price will decline, a covered put can be a profitable strategy.
High Volatility
Stocks with high volatility often have higher option premiums, making them attractive candidates for covered put strategies. By selling put options on volatile stocks, investors can potentially generate more income.
Risks of Covered Puts
Unlimited Loss Potential
While the covered put strategy does provide some level of protection, it’s essential to remember that the potential loss is still unlimited. If the stock price rises significantly, the short position’s losses can be substantial.
Margin Requirements
Shorting stocks requires a margin account, which can come with additional costs and risks. Be sure to understand your broker’s margin requirements and the potential consequences of a margin call.
Examples of Covered Puts
Example 1: Basic Covered Put
Let’s say you believe that XYZ stock, currently trading at $50, will decline in value. You decide to execute a covered put by selling a put option with a strike price of $45 and shorting 100 shares of XYZ stock. The put option premium is $2 per share, generating $200 in income. If the stock price declines, you can buy back the shares at a lower price and profit from the difference. If the stock price increases, the put option will expire worthless, but you’ll still keep the premium.
Example 2: Rolling Covered Puts
Another strategy is rolling covered puts, which involves selling a new put option when the previous one expires. This can generate additional income and extend the hedge provided by the put option.
Key Takeaways
Covered puts are an options trading strategy that involves selling a put option while simultaneously shorting the underlying stock.
This strategy can generate income from the premium received for selling the put option and provides a hedge against potential losses from the short position.
Covered puts are most effective when used in a bearish market outlook or with high volatility stocks.
Risks associated with covered puts include unlimited loss potential and margin requirements.
Tips for Trading Covered Puts
Monitor Market Conditions
Keep an eye on market trends and news that may impact the stock price. By staying informed, you can make better decisions about when to enter or exit a covered put position.
Diversify Your Portfolio
Although covered puts can be a profitable strategy, it’s essential to diversify your investments to minimize risks. Consider incorporating other strategies, such as covered calls or credit spreads, to create a balanced portfolio.
Set Stop-Loss Orders
To manage the risks associated with shorting stocks, consider setting stop-loss orders. These orders automatically close your short position if the stock price reaches a predetermined level, limiting your losses.
How to Choose the Right Stocks for Covered Puts
Evaluate the Fundamentals
Look for stocks with strong fundamentals, such as solid earnings, cash flow, and a competitive position in the market. These factors can help you identify stocks with the potential for price declines, making them suitable candidates for covered puts.
Analyze Technical Indicators
Technical indicators, such as moving averages, relative strength index (RSI), and Bollinger Bands, can help you identify entry and exit points for covered put positions. By analyzing these indicators, you can determine the optimal timing for executing a covered put strategy.
Covered Puts vs. Covered Calls
While both covered puts and covered calls involve selling options to generate income, the primary difference lies in the underlying stock position. With covered puts, you short the stock, while with covered calls, you own the stock. Covered calls are typically used when an investor has a neutral to moderately bullish outlook on the stock, while covered puts are used when an investor has a bearish outlook.
Conclusion
Covered puts can be an effective strategy for generating income and managing risks in a bearish market. By selling put options while shorting the underlying stock, investors can profit from premium income and potential price declines. However, it’s essential to understand the risks associated with this strategy, such as unlimited loss potential and margin requirements. By carefully selecting the right stocks, monitoring market conditions, and managing risks, covered puts can be a valuable addition to your options trading toolkit.
Frequently Asked Questions (FAQs)
What is a covered put example?
Imagine a stock called ABC is trading at $100. You believe the price will go down. You sell a put option with a strike price of $95 and short 100 shares of ABC stock. You receive a premium of $3 per share for selling the put option. If the stock price falls, you can buy back the shares at a lower price and make a profit. If the price goes up, the put option expires worthless, but you keep the premium.
What does it mean to cover puts?
To cover puts means to sell put options while simultaneously shorting the same number of shares of the underlying stock. This strategy is used to generate income from the put option premiums and hedge against potential losses from the short position.
What is the benefit of a covered put?
The main benefit of a covered put is the ability to generate income from selling put options while also having a hedge against potential losses from shorting the stock. This strategy can be profitable when you have a bearish outlook on the stock.
How risky is selling covered puts?
Selling covered puts has risks, including unlimited loss potential if the stock price rises significantly. The short position’s losses can be substantial. Additionally, shorting stocks requires a margin account, which has its own risks and costs.
Is a covered put bullish?
No, a covered put is not bullish. It’s a strategy used when an investor has a bearish outlook on a stock, meaning they believe the stock price will decline.
Is it better to sell covered calls or covered puts?
It depends on your market outlook. If you have a neutral to moderately bullish outlook, selling covered calls might be a better choice. If you have a bearish outlook on a stock, selling covered puts could be more suitable.
How much can you lose on a covered put?
While the potential profit from a covered put is limited to the premium received, the potential loss is theoretically unlimited. If the stock price rises significantly, the short position’s losses can be substantial.
Do you need 100 shares to sell covered puts?
No, you don’t need 100 shares to sell covered puts. Instead, you need to short 100 shares of the underlying stock while selling one put option contract, which typically represents 100 shares.
When should I buy covered puts?
You should consider using a covered put strategy when you have a bearish outlook on a stock and believe the stock price will decline. This strategy can help generate income and provide a hedge against potential losses.
What is a poor man’s covered put?
A poor man’s covered put is a variation of the covered put strategy that involves buying a longer-dated put option with a lower strike price, instead of shorting the stock. This can reduce the capital required and margin risk but may have lower profit potential compared to a traditional covered put.