A covered put is an option strategy where an investor writes a put option while shorting the shares of the underlying stock.
The covered put can be used when an investor is trying to increase his profits from shorting the underlying stock or when he is protecting his short position against a slight rise in the price of the underlying stock. This article will give investors a better understanding of this effective option strategy.
An investor who uses the covered put has a neutral to slightly bearish sentiment on the underlying stock.
The maximum profit an investor gains from this strategy is equal to the premium received for the option sold. Therefore, the potential gain is limited.
On the other hand, the potential loss is unlimited. In the worst-case scenario, the stock price expires above the strike price. If this happens, the investor is left with a short stock position while the price of the stock is rising. Since there is no limit on how much the stock could rise, the potential loss is unlimited.
Let’s look at an example of this strategy.
Assume stock ABC is trading at $30. An investor writes a covered put by selling a put option with a strike price of $30 that expires in a month. He receives a premium of $200, which is his potential maximum profit. At the same time, he shorts 100 shares of ABC stock.
At expiration in one month, if ABC is still trading at $30, then the put option will expire worthless. The option seller will cover his short position with no loss and will walk away with a profit of $200.
If ABC falls to $27 at expiration, then the put option would be exercised. If this happens, the option seller is obligated to buy the shares of stock at $30 rather than $27. That is a $300 loss. However, he also shorted the stock at $30. From that, he made a $300 gain. The $300 loss from the option is offset by the $300 gain in the short position. The investor walks away with a profit of $200 because of the premium paid to him.
If the stock rises in price to $35 at expiration, then the option seller is going to incur a loss. The short stock position will suffer a loss of $500. However, the option seller is gaining $200 from the premium. In total, the option seller is going to lose $300.
These are the possible results for a covered put strategy. The best result occurs when the underlying stock price remains relatively neutral.
If an investor feels that a stock price is going to remain neutral over a certain time period, then using the covered put is a great strategy to earn a small profit.