Introduction To A Covered Put
Writing covered puts is the simultaneous shorting of the underlying security and the writing of puts against the short position of the underlying security. The covered put limits profits to the upside but as the price of the underlying security increased, losses increase as well. This can be seen by the graph above. The following steps help one to execute the covered put strategy correctly to profit from it.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Bearish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Possibility Of An Unlimited loss
Step 6 : Possibility Of An Unlimited loss
Step 7 : Loss Calculation Of A Covered Put
Step 8 : Understand That Profit Is Capped
Step 9 : Profit calculation of a covered put
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a covered put
Step 12 : Exiting the covered put position
Step 1 : Perform economic, fundamental and technical analysis
It is important to assess the outlook for an underlying security before executing the trade. With poor a poor economic outlook, there is a high probability that the outlook for equities would be poor as well. For example, in a recession, most stocks follow the downward direction of the general market. It is advisable to conduct economic analysis first, followed by fundamental analysis and technical analysis to determine the direction of a security. For covered puts, traders are looking for bearish cues in the market and the security. Fundamentally, the security may see a 10% decline in price due to a poor business decisions made by the management, which cause earnings per share to shrink from one quarter to another. Of course, a decline in price of the underlying security will play out in many ways. For more, please read Basic Economic Analysis , Basic fundamental Analysis and Introduction to technical analysis . There are some chart patterns that option traders can look at when executing covered puts :
Step 2 :Outlook – Bearish
Writing covered puts is a bearish option strategy. At this point, the options trader should have some evidence that an underlying security is likely to be bearish. The trader is making the bet that the price of the underlying security will decline due to broad market, the fundamentals and weakening technical outlook. When that happens, the trader can realise a profit from the trade.
Step 3 :Study the option chain
The option trader should look at the option chain. Be mindful of the price of the underlying security and select a put option that he is willing to write. The put option could be ATM, ITM or OTM. Also, investigate implied volatility to determine whether an option is undervalued or overvalued.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
Now, the options trader can perform breakeven analysis.
The breakeven price point can be calculated as :
Short sale price of the underlying security + total premiums received from writing puts
This is the price point at which there is neither profit or loss. Option traders should take note of this point.
Step 5: Understand Your Profit Zones
After the breakeven price point has been calculated, a trader will understand his or her profit zone. As long as the price of the security trades below the breakeven point, the trade would be profitable.
Step 6 :Possibility Of An Unlimited loss
Since the price of the underlying security can go up indefinitely and infinitely, there is no limit to the loss that a trader can make with a covered put strategy. That is because shares were shorted to enter the trade. When the price of the underlying security goes higher, closing out the trade may mean buying to close at an exorbitantly high price which may result in a loss. This loss occurs when specifically when the sum of the sale price of the underlying security and the net premiums received is less than or equal to the trading price of the underlying security.
Step 7 : Loss Calculation Of A Covered Put
The loss can be calculated as :
Trading price of the underlying security – Sale price of the underlying security(price at which underlying security was shorted) – total premiums received from writing put + commissions paid to the broker
Step 8 : Understand That Profit Is Capped
The profit is limited in a covered put trade. The maximum profit occurs when the price of the underlying security is less than or equal to the strike(exercise) price of the written put.
Step 9 : Profit calculation of a covered put
The profit can be calculated as :
Net premiums received from writing put – commissions paid to broker + Short Sale Price – Strike Price of Puts
Step 10 : Calculate Risk & Reward Ratio
Once the maximum profit can be calculated, supposing that the appropriate stop losses are in place, the options trader can calculate the risk reward ratio. For example, if the trade’s risk to maximum reward is $1 of risk to $3 of maximum gain, the option trader may deem the trade attractive. Of course, this must pass through the lens of the option trader, relative to the other covered puts he has done in the past. If the risk and reward ratio is not attractive relative to another option strategy, the option trader may abandon the covered put strategy. Or he may modify the strategy a little in terms of the strike price of the puts used.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade : Executing a covered put
For every 100 shares of the underlying security shorted, write a put option simultaneously. The puts could be ATM, OTM or ITM.
Step 12 : Exiting the covered put position
- If the price of the underlying security falls below the strike(exercise) price of the put, the short put is assigned. The put writer is obligated to buy 100 shares of the underlying security from the assigned option buyer at the strike(exercise) price of the option. The put writer garners a maximum profit that is equal to the difference between the short sale price and the buying price of the shares added to the put premium collected.
- If the price of the underlying security declines to less than the price at which the stock was shorted initially but remains above the strike(exercise) price, the written put expires worthless and the trader gets to keep the premium from the shorted put. The trader can choose to short another put to collect more premium over time. No losses are incurred.
- If the price of the underlying security rises above the short sale price of the stock and stays below the breakeven point, the short stock position will start to lose money. This loss is of course offset by the premium received from shorting the put. A small profit may be realisable in this scenario.
- If the price of the underlying security increases above the breakeven point, the trader can choose to let the option expire worthless. The premium collected acts as a slight hedge against losses in the short stock position.
Step 13 : Record Trade In Diary
After the trade has been exited, it is recommended that the trader records the trade in a trading diary, recording profits, losses, profit percentages and loss percentages. This way, the trader is able to determine the mistakes that he has made in the trade and improve on his personal trading algorithm.
Example
ABC Corp is trading at a price of $35. A trader is bearish on the company and executes a covered put, shorting 100 shares at a price of $35 and writing an ATM June 35 put and receiving $2 for it. The net credit is thus:
$2 x 100 = $200
Scenario analysis
| Price of ABC | Short sale price of ABC | Beginning value of put as trade was initiated | Ending value of put | Net gain/loss of put on expiry | Net gain/loss on ABC stock | Overall gain/loss on trade |
| $30 | $35 | $2 | $5 | Loss = $3 | Gain = $5 | Gain = $2 |
| $35 | $35 | $2 | $0 | Gain = $2 | Gain = $0 | Gain = $2 |
| $40 | $35 | $2 | $0 | Gain = $2 | Loss = $5 | Loss = $5 – $2 = $3 |
| $60 | $35 | $2 | $0 | Gain = $2 | Loss= $60 – $35 = $25 | Loss = $25 – $2 = $23 |
As you can see, the maximum gain or profit is equal to the initial credit of $2 received for writing the put. Hence, maximum profit = $2 x 100 = $200
When the price of ABC trades at $40, the trader makes a loss of $3 x 100 = $300
But when the price of ABC trades at $50, the losses mount and becomes $23 x 100 = $2300. Hence, there is always a potential for unlimited loss as the price of the stock can rise infinitely theoretically.
Margin requirement for covered puts
Margin is required for covered put positions. The amount of margin required is entirely within the discretion of the broker that is used.
Covered put vs naked call
The covered put strategy is similar to the naked call strategy. The difference is that naked call writing uses call options. Read :
Writing Naked in the money calls to collect premium : A bearish options strategy