Covered Put

[Igor 10]

Traders who implement covered put strategies are betting that the market price of an option's underlying asset will fall. The technique involves short selling owned assets and selling a put option for the same amount of shares. The loss-risk in this strategy is unlimited, if the market price of the underlying asset rises. Traders who employ covered put strategies use their assets as leverage to earn a fixed premium credit, which is received from the put buyer when entering the market.

 

Moneyness Review for Puts

Out-of-The Money (OTM) = Strike Price (less than) Market Price

In-The-Money (ITM) = Strike Price (more than) Market Price

At-The-Money (ATM) = Strike Price (equals) Market Price

 

How to Carry out Covered Puts Strategies

 

 

Disney stock is worth $45 (market price) in June.

1) Trader short sells 100 shares of Disney stock

2) Trader sells the put option: DISJul45($2)

- 100 shares of Disney stock

- Strike Price $45, at-the-money (ATM), expiring in 30 days

- Premium Cost of $2

3) Trader receives a $200 credit when entering the market [$200 (received from put buyer)]

Total cost to enter the market: -$200

 

Result one: Disney stock remains at $45 in July

a) The put option sold expires worthless (OTM)

b) The short sale realizes no gain.

c) Trader profits total $200 after keeping the credit earned when entering the market.

 

Result two: Disney stock falls to $40 in July.

a) The short sale realizes a $500 gain, and the trader receives $500.

b) The put option sold expires ITM.

c) The investor who bought the trader's put option exercises his or her right to sell 100 shares at $45. The trader pays $4500 to the buyer, and receives 100 Disney shares.

d) The trader immediately sells the 100 shares in the open market and receives $4000.

e) The trader makes a total profit of $200 after keeping the credit earned when entering the market. [$200 = $4000 (received for 100 shares) + $500 (gain from short sale) + $200 (credit to enter market) - $4500 (paid for 100 shares)]

 

Result three: Disney stock rises to $55 in July.

a) The short sale realizes a $1000 loss, and the trader pays $1000.

b) The put option sold expires worthless (OTM)

c) The trader loses $800 after adding the credit earned when entering the market. [-$800 = $200 (credit to enter market) - $1000 (loss from short sale) ]

 

Advantages and Disadvantages in Carrying Out Covered Put Strategies

 

Pluses: The upside to this type of strategy is that the investor will gain limited profits if the put option expires at-the-money or expires at any price below it. Profits remain the same, independent of how low the market drops. Covered put strategies also earn traders a credit when entering the market, which can be used to offset losses if the underlying asset's market price rallies.

 

Minuses: The downside in using covered put strategies is that the method has an unlimited loss-risk potential. The short sale exposes traders to high risk when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only what he or she received when entering the market. Investors can not profit from their short sale if the market crashes because the put option would offset any gains.