A covered put is a bearish options strategy that involves holding a short position in a stock and simultaneously selling (writing) put options on the same stock. This approach allows investors to generate potential income through the premiums received from the sold put options while maintaining their short stock position. However, it also introduces risks, particularly if the stock price rises significantly.
In a covered put setup, the investor:
Shorts 100 shares of a stock or ETF.
Sells one put option per 100 short shares, typically at an out-of-the-money (OTM) strike price.
This strategy allows investors to generate potential interim income on their short positions. However, it caps profits and exposes the investor to unlimited risk due to the short shares.
The profit and loss (P&L) profile of a covered put strategy is characterized by:
Maximum Profit: Achieved when the stock price declines to the strike price of the sold put option. At this point, the option may be exercised, and the investor buys the stock at the strike price to cover the short position, realizing gains from both the stock's decline and the premium received from selling the put.
Break-even Point: Calculated by adding the premium received to the short sale price of the stock.
Maximum Loss: Occurs if the stock price rises indefinitely, as the potential loss on the short stock position is unlimited. The premium received from the sold put offers only minimal mitigation against such losses.
This strategy provides limited profit potential due to the obligation to buy back the stock at the put's strike price if exercised. However, it offers some income generation through the premium received.
The terms "covered put" and "sell-write" are often used interchangeably but refer to slightly different actions:
Covered Put: Involves selling a put option against shares of stock that are already sold short.
Sell-Write: Involves shorting shares of stock and simultaneously writing (selling) put options against those shares.
Both strategies aim to generate income through the premiums received from selling put options, but the sell-write strategy is executed as a single transaction.
To implement a covered put strategy, an investor needs:
Short Stock Position: At least 100 shares of the underlying stock or ETF sold short per put option sold.
Approval for Options Trading: Authorization from their brokerage to engage in options trading, specifically the ability to sell put options.
Margin Account: Establishing or maintaining a short stock position is only allowed in a margin account, so implementing a covered put in any other kind of account is not permitted.
Stock Short Sale Price: $50 per share
Number of Shares Shorted: 100
Put Option Sold: One OTM put option with a strike price of $45, expiring in one month, premium received $2 per share
Stock Price Above $50:
Stock Loss: Unlimited potential loss as the stock price rises
Option Premium: $2 per share
Net Loss: Unlimited potential loss, slightly offset by the premium received
Stock Price Between $50 and $45:
Stock Gain: $0 to $5 per share
Option Premium: $2 per share
Total Gain: $2 to $7 per share
Stock Price Below $45:
Stock Gain: $5 per share
Option Premium: $2 per share
Total Gain: $7 per share (maximum profit)
In this example, the maximum profit of $7 per share is realized if the stock price is at or below $45 at expiration. The premium received provides a buffer against minor increases in the stock's price.
To sell a covered put:
Ensure Short Stock Position: Hold at least 100 shares of the underlying stock or ETF in a short position.
Select a Put Option to Sell:
Strike Price: Typically below the current stock price (OTM) to allow for some profit from the short position.
Expiration Date: Choose based on income goals and market outlook; shorter expirations provide quicker premium decay.
Place the Trade:
Order Type: Sell to open one put option contract for every 100 shares shorted.
Monitor the Position: Keep track of the stock price relative to the strike price and be prepared for potential assignment if the stock trades below the strike price as expiration approaches.
It's essential to understand the obligations associated with selling put options, including the potential requirement to buy shares at the strike price if the option is exercised.
The maximum profit is capped at the put strike price because the short stock position gains are offset by the obligation to buy back shares if assigned.
Even if the stock drops significantly, gains are limited by the short put position.
Unlike a covered call, a covered put has unlimited risk if the stock price rises.
Since there is no cap on how high a stock can rise, the short stock position could suffer large losses if the stock rallies.
The sold put option loses value over time, which benefits the trader if the stock stays above the put strike price.
If the stock remains above the short put's strike, the option expires worthless, and the investor keeps the premium.
If the stock price drops below the short put's strike price, the option may be assigned early, requiring the investor to buy back the short stock at the strike price.
This assignment locks in profits on the short position but caps further downside gains.
Rolling the Short Put Forward
If the stock price remains above the put strike price, the investor can roll the short put to a later expiration to collect more premium.
This extends the strategy while still maintaining the short stock position.
Closing the Trade Early
If the stock drops significantly before expiration, the trader may choose to close both legs of the trade (short stock + short put) to lock in profits early.
Alternatively, if the stock rallies unexpectedly, the trader may close the short put and adjust the short stock position accordingly.
Letting the Option Expire
If the stock stays above the put's strike price, the option expires worthless, and the investor keeps the premium.
The investor can then sell another put to generate additional income while maintaining the short stock position.
| Strategy | Market Bias | Maximum Profit | Maximum Loss | Best Used When... |
|---|---|---|---|---|
| Covered Put | Moderately Bearish | Capped at put strike + premium received | Unlimited (if stock rallies) | You want to generate income while holding a short position |
| Short Call Spread | Bearish | Limited (premium received) | Limited (spread width) | You want a defined-risk alternative |
| Short Stock | Strongly Bearish | Unlimited (if stock drops) | Unlimited (if stock rallies) | You believe the stock will decline significantly |
| Bear Put Spread | Moderately Bearish | Limited (spread width - premium paid) | Limited (premium paid) | You want a defined-risk way to profit from a decline |
If you already have a short stock position and want to generate additional income.
If you expect the stock to decline gradually, rather than a sharp drop.
If implied volatility is high, allowing for larger premiums when selling the put.
| Strategy | Best Used When... |
|---|---|
| Short Call Spread | You want to profit from a bearish move with defined risk. |
| Protective Call (Hedge on Short Stock) | You want to cap risk on a short stock position. |
| Bear Put Spread | You want a directional trade with limited downside risk. |
| Cash-Secured Puts | You want to generate income but are willing to buy stock at a lower price. |
The covered put is an advanced bearish strategy that generates income from short stock positions. It works best when:
However, because profits are capped and losses are unlimited on the short stock, this strategy requires active trade management and strict risk control.
Covered puts generate income by selling puts against short stock.
The strategy works best in moderately bearish conditions, but strong rallies can cause large losses.
Managing risk is crucial, as short stock positions have unlimited downside potential.
Rolling or closing early can help optimize trade performance and limit losses.
Since this strategy involves short stock exposure, it is best suited for traders who understand margin requirements and bearish positioning.