Options are an exotic seasoning used to spice up the investment world. We’re seeing them more and more as investors learn about their unique applications. They allow you to do things that might sound like ‘finance fiction’ to those unaware; like making money no matter what direction a stock moves, or using them as insurance that will protect your investments.
What else can they do?
True or false: using a single option play, you can earn money on an investment if it goes in the right direction, and if it goes in the wrong direction, and you can buy stocks at a discounted rate to their current price. Answer: True.
The reason? Covered puts. To be fair, there are also covered calls involved, but we’ll just be reviewing covered puts in this article.
If you know how to use options correctly, you can use them as a sort of insurance to protect an investment. In the case of a covered put, you are not only protecting your investment from downside risk, but you are receiving cash via premium instantly, which is the main draw to this strategy.
With covered puts, the other party involved pays you a premium for you selling them a put, aka the right to sell stock at a set price over a set period of time. Once you possess that put contract, in one sense it acts as a shield in the case that the underlying share price moves in the wrong direction towards its break-even. And in another sense, it serves as a profit if the stock’s price moves sideways or down, but stays above its strike price. So there is a lot of potential with this play!
We’ll give you a complete guide of a covered put, including what they are in the first place, how to use them, when to use them, and show you the factors that affect them.
What’s a Covered Put?
A covered put is essentially a strategy where you sell someone the right (but not the obligation) to sell 100 shares of a stock at a set price over a set period of time, and receive money, or a premium, by doing so.
The strategy is composed of two trades: one where an investor shorts 100 shares of a stock, and the second is when the investor sells a put option, at, or out-of-the-money. If you have heard of covered calls, these work very similarly, only with covered puts you are shorting the underlying position and not longing it. It’s important to note before going any further that covered puts are not the same as cash-secured puts.
You can also think of a covered put as an exchange between two parties. Party 1, the one employing the covered put strategy, thinks that the underlying stock price is going to go down slightly. By employing this strategy, this investor receives a premium from the other party, because the other party purchased a put that gives them the right to sell stock at a set price over a set period of time. In addition to receiving the premium upfront, the investor would also profit from their short position if the underlying share price goes down, but stays above the strike price.
Now the other party, Party 2, the one purchasing the put, thinks that the underlying share price is going to go below the strike price. If it does, the investor selling the put will be assigned the shares, obligating them to buy 100 shares of the underlying stock.
So if you decide to employ this strategy, you must have enough capital to cover the cost of 100 shares of the stock you choose, because by selling the put option, you are obligated, not given the “right”, to buy 100 shares at the strike price. This is a common mistake when using options, but it can very easily be avoided. It’s a good idea to just set the money aside before employing the strategy.
Another important thing to be aware of is that while this strategy is attractive in that you receive a premium instantly, your profit is limited to that, plus the profit you would earn if the stock goes down before the contract expires. Moreover, you expose yourself to a decent amount of risk if you use this strategy because with your short position your loss potential is theoretically infinite.
However, this strategy, despite not being able to protect against upward price movement, has a nice silver lining. If you are assigned the shares, you are essentially getting them at a discount. So if you’re interested in initiating a position in a stock, a put strategy could be a great way to do it. This is because you can deduct the premium you receive by selling the put contract to the total cost of the shares you were assigned.
Example of a Covered Put
Okay so now that we’ve touched on what a covered put is, let’s look at some examples. We’ll go over two here; one that’s a classic situation of using a covered put, and another where you can take advantage of the benefits of covered puts by essentially discounting the price of buying 100 shares of a stock you want to own.
Example 1: A Classic Covered Put
We’ll use Home Depot (HD) for the first example.
Let’s say HD is trading at $315.00 and you’re slightly bearish on the stock because lumber prices seem to be falling. To employ a covered put strategy, you’ll want to first make sure you have enough to buy 100 shares of the underlying stock (in this example $31,500) in the case that the contract is assigned to you.
Next, you will short the 100 shares of HD, and also sell a put option with a strike price slightly below its current share price, say that’s $311.00, and the option expires in one month. You received a premium of $0.65 per share, for a total of $65.
After one month, at the time of expiration, the stock is trading at $312.00. The contract was never assigned to you because it did not go out-of-the-money, so the contract expired worthless.
You can now close the position where you shorted HD. The total profit gained is the $65 received via the premium, and $300 from the short position ($315 – $312 = $3; $3 * 100 = $300.00; $300 + $65 = $365.00).
Now let’s look at an example of where you’d want to be assigned the shares.
Example 2 – When You Want to Initiate a Position Through a Put
We’ll use Pfizer (PFE) in this example.
Let’s say PFE is trading at $45.00 at the time you decided to use a covered put. You are bearish in the short-term, but you’re bullish in the long-term so you want to eventually purchase some of the stock, but you know you could use a put to purchase the shares at a discount.
To perform the strategy, you’ll short 100 shares of PFE, and then sell a PFE put option that has a strike price slightly below what the stock is trading at, say the strike is $44.00, and has an expiration date 3 weeks out from when you sold it. $44.00 is a good strike price for this strategy because when you want to eventually initiate a position with the stock, you’ll want the contract associated with it to be either at-the-money (ATM) or slightly out-of-the-money (OTM)—we’ll explain why in the next section.
Fast forward to the date of expiration and the stock is trading at $43.00, so the shares are assigned to you and you’re obligated to purchase them. This is the complete covered put strategy, but let’s talk about the benefits received through the effect of this strategy.
You can subtract the capital received from the premium you received by selling the put, and the capital received from closing the position with the shares you shorted, from the total price of purchasing 100 shares.
[(100 * current share price) – (Premium + Profit from closing short position) = Discounted price of stock]
If the premium received was $0.50 a share ($50.00) and the profit received from closing your short position was $200.00 ($45 – $43 = $2; $2 * 100 shares = $200). If you were assigned the shares when the underlying price was trading at $41.00, it would cost you $4,100 – $250 = $3,850.00, which is over a 5% discount.
When to Use a Covered Put: Strategy
The two best times to use a covered put are when you think a stock’s underlying share price won’t move very much, or fall slightly but stay above its put’s strike price before its expiration date, or when you want to initiate a position with a stock and get the shares at a discount. Essentially, this is what we showed in the above examples. Covered puts can provide you a way to earn an instant premium, and either end up profiting or buying stock at a discount.
But let’s say you’re interested in initiating a position with a stock, and you think it’s going to go down slightly in the short term. You can also use a covered put for this.
Typically you’d want the put to be as close to at-the-money (ATM) as possible. This would offer you a higher premium, while still lending you a good chance of the shares being assigned to you. So you short 100 shares of a stock, sell a put of the same underlying stock (thus receiving a premium). The underlying price moves down, past the strike, so it’s out-of-the-money (OTM).
Now you have the premium collected from selling the put, money (not profit in this case) from the price moving down by shorting it, and now you’re been assigned the shares. The money received can be used to reduce the total cost of purchasing the assigned shares, and now you’ve entered into the position with a nice discount.
How Does a Covered Put Help with Risk Management?
The very nature of covered puts is proper risk management. The two trades work symbiotically to balance each other. Puts are often used to create this balanced relationship between investments.
You can essentially hedge risk against positions in your portfolio. For example, if you wanted to long 100 shares of a stock, you could purchase a put alongside it in case you wanted to exercise the option if the price moved lower than you’d like.
One way that a covered put helps with risk management is how the strategy awards you premium instantly. So after you receive the premium, you just have to hope that you can keep that profit. But the premium protects you from the risk of the underlying price moving up, so the premium is what creates a break-even point, as it protects you from losing money from small upward movements.
Important Factors that Can Impact a Covered Put
The premium you receive by selling a put is the focal point of the covered put strategy. All the factors that can impact the premium you can receive by selling puts should be taken into account. Some of the chief factors that impact an option’s premium are time decay and implied volatility. Let’s talk about how.
Going back to the perspectives of each party in a covered put interaction, Party 2, or the person purchasing the put contract on the other end, wants the underlying price to go below the strike price so they can sell for more than what the stock is trading at. The more time the stock’s price has to move into the money, the more valuable the contract will be, thus creating a higher premium.
With that understanding, we can infer that as time progresses, the option’s premium will slowly go down. So the further the expiration date is for the put seller, the better, as the premium will statistically be higher.
Implied volatility, or IV, also plays a huge role in the option’s premium. IV and the option’s premium are directly correlated; so as IV increases, so does the option’s premium.
Sometimes, an option’s IV gets crushed after a sudden change in an option’s premium, perhaps most commonly seen as a result of a company’s earnings report being released. Seeing a company’s earnings report, investors have confidence in an ‘actual’ stock’s price. And confidence is at an all-time low just before earnings, and an all time high right after.
Confidence affects volatility, volatility or IV affects an option’s premium (their relationship is correlated), and premium is the nucleus of a covered put strategy. So it would behoove someone using the strategy to look at an earnings report calendar, and try to avoid the times when IV tends to get crushed after they’re reported.
When volatility spikes or plummets, capitalize on it. And in the case of covered puts, you want the premium to be higher, so buy when the IV is higher. If you hold the position too long, you’ll miss out on those short-term opportunities to profit more than if you hold the position through those movements.
So what’s the most you can lose and the most you can gain when using covered puts?
Max Loss with a Covered Put
Unfortunately, the potential max loss of a covered put is significantly greater than the max gain. It’s unlimited because you are holding a short position and nothing on the other side to mitigate that upside risk. You can always close the short position, of course, but the max potential is unlimited.
The max loss associated with a covered put is tied to the share price of the underlying stock, which can theoretically fall to zero. So with the shares that you short, if you let them sit and don’t close the position, your loss would be equal to the stock price * (at least) 100 shares.
Covered puts only protect you if the underlying price falls but stays above the strike, or stays the same, but it does nothing to protect you if the price increases past the breakeven point of the profit from the initial premium.
What’s the Max Gain with a Covered Put?
The max gain associated with a covered put is equal to: [(underlying share price at the time you short it + premium – strike price) * 100].
Say the stock you’re going to trade is trading at $100.00, the option’s premium is $1.50, and the strike price is $98.00. Fast forward to when the option expires, and at the time of expiration, the stock was trading at $99.50. So you have:
($100 + $1.50 – $99.5) * 100 = $200.
In Summary: Pros and Cons of a Covered Put
Covered puts are the yang to covered calls yin. They are very similar, just inverted, essentially. Covered puts are like a rifle in bear territory, but a stick in bull territory.
Covered puts can be beneficial in several ways. If a stock goes down and you close your position before expiration, you’ll make money in two ways. Both from the premium received initially, and the profits from the short position. And even if the price moves sideways, you might not profit from the short position, but you have that premium locked in already. So if it goes sideways or down and doesn’t fall below the strike before expiration, you’re in good shape.
But, you can even still earn profit from a covered put if the underlying price goes up, so long as the premium you earn isn’t less than what you lose from the short position.
The cons of covered puts come when the stock moves up. There is very little protection for you if the stock price moves up, only a little premium shield to protect you. If you don’t close your position, and the underlying price moves high enough to where your loss with the short position is more than the amount you received from the premium, your loss potential is unlimited.
But wait, remember that covered puts have one more trick up their sleeve. Basically, if you end up getting assigned the shares, you get them at a discount no matter what, because you can apply the premium initially received to the overall cost of 100 shares of the underlying.
Trading the Covered Put: FAQs
How Does a Covered Put Differ from a Cash Secure Put?
The difference between a cash secure put and a covered put, is with a covered put, you are shorting shares of a stock while also selling a put. With a cash secure put, you are also selling a put option, but you aren’t shorting shares of the same underlying security, you’re just setting aside the money necessary to buy the 100 underlying shares if they “put” to you, or if you’re assigned the contract.
Can You Lose Money on a Covered Put?
You can certainly lose money on a covered put. In fact, you can lose everything on a covered put. While covered puts are an attractive investment for those that find themselves employing the strategy and the underlying stock moves slightly down or sideways, you’ll be sorry if you are using a covered put and the stock shoots up in price.
For every cent that the underlying share price increases past the break-even point, you lose that money. You are only protected, or covered, if the price goes down too far, not too high.
Do You Use a Covered Put in a Bear Market?
You can absolutely use a covered put in a bear market, and the strategy can be very profitable in those markets. You just have to be careful of the underlying share price falling below the put’s strike price.
Notice that throughout this article, we say to use covered puts when you think the underlying price is going to move slightly down. This is because if it moves too far, as we’ve discussed, you’ll miss out on the profit from the short position and only receive the premium from selling the put.
When Should You Sell Covered Puts?
There are two optimal scenarios when you should sell covered puts.
One: when you think a stock’s price is going to remain relatively constant within a set period of time, or slightly fall within a set period of time (amount of time before a put’s expiration date).
Two: when you want to initiate a position with a stock, even if you feel that the underlying price could go down in the short term.
We talked about the second option above, but we’ll do a quick summary. Basically, if you want to long stock, even if the stock’s price goes down temporarily in the short term, you can use a covered put to guarantee you’ll get the shares at a discount if its price falls below the strike because you can deduct the premium from the total cost of the 100 shares.
What’s a Cash Covered Put?
A cash covered put is a more advanced trading strategy that consists of two trades, and is used typically when an investor thinks a stock’s price will stay the same, or go down slightly. In one of the trades, the investor sells a put option, and in the other trade, the investor shorts 100 shares of the same underlying security. The investor profits from the premium they earned selling the put, and any money they make if the price goes down, so long as the contract doesn’t expire out-of-the-money.