Covered puts are basically a bearish options strategy that consists of writing put options whilst simultaneously shorting the equivalent number of shares in the underlying stock.
Here’s how it works: Short 100 Shares – Sell 1 At The Money (ATM) Put
The maximum possible profit possible using a covered put is limited to the premium received for the options sold.
You can calculate the maximum profit possible using a covered put by using the formula below:
- Max Profit = Premium Received – Commissions Paid
- Max Profit Achieved When Price of Underlying = Strike Price of Short Put
Since you have to actually short the stock that’s covering the put you’re theoretically exposed to a considerable amount of risk, since the underlying stock could rise in value. In reality you can mitigate this risk by using a stop loss on your stock trade. There are still significant risks involved when using this strategy however. To ensure you’re aware of the risks involved use the following formula for calculating the maximum possible loss for each trade.
- Loss Occurs When Price of Underlying >= Sale Price of Underlying + Premium Received
- Loss = Price of Underlying – Sale Price of Underlying – Premium Received + Commissions Paid
The underling price at which breakeven is achieved can be calculated by using the following formula.
- Breakeven Point = Sale Price of Underlying + Premium Received
Covered Put Example
Let’s say Bank of America (BAC) is trading at $45 in April. So you decide to write a covered put by selling a MAY 45 put for $200 while shorting 100 shares of BAC stock. The net credit taken to enter the position is $200, which is also your maximum possible profit.
Upon expiration in May, BAC stock is still trading at $45. The MAY 45 put expires worthless whilst you cover your short position with no loss, save for a small commission. In the end, you get to keep the entire credit taken as profit.
But what if BAC stock drops to $40 upon expiration, the short put will expire in the money and is worth $500 but this loss is offset by the $500 gain in the short stock position. Thus, your profit is still the initial credit of $200 taken on entering the trade.
The final scenario is if the stock rallies to $55 upon expiration, this would result in a significant loss. At this price, the short stock position taken when BAC stock was trading at $45 suffers a $1000 loss. Subtracting the initial credit of $200 taken, results in a loss of $800.
To make the above example easier to understand we’ve left out trade commissions. These are payable to your broker for every options trade you make. In the case of covered puts you’ll also have to pay commission for the subsequent stock trade.
You can reduce the amount of commission you have to pay however by using a broker that specializes in frequent trading. A good example would be OptionsHouse as their commissions start as low as $0.15 per contract (+$8.95 per trade).
Don’t make the mistake of signing up for a broker like this in the beginning though. As a rookie you’re much better off choosing a broker that offers proper training and education. A sound education will more than offset the higher trading fees in the beginning. As you mature as a trader you can always move your account.
The covered put strategy is an excellent strategy to learn and it definitely should be a part of your arsenal if you intend to take options trading seriously. But be aware that this strategy isn’t for the unwary.
You’re exposed to huge potential losses if you don’t trade with care and have proper stop losses in place. For this reason I recommend you try it out in a virtual environment before you commit any real capital.