Covered Put

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21 Aug, 2024

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A covered put is when an option is written against a short position when a share is borrowed and sold on the market. Covered puts are used in short selling and are most suitable when the trader has a neutral to negative market sentiment.

A person shorted a share must first sell a put option contract on that stock before implementing the covered put technique. When one sells a put option, they are essentially capping their gains and sealing in the underlying asset's price.

What Is A Covered Put?

A covered put occurs when an option is written against a short position when a stock is borrowed and sold on the market.
A covered put is a pessimistic strategy, an abbreviated variant of a covered call. And it rewards a premium to the seller of a put option contract.
Most investors should avoid pursuing this high-risk approach since it has a very low return potential and may be exposed to infinite potential dangers.
It involves both the risk of expiration and the risk of assignment.

Covered Put Options Explained

A covered put or covered put option is a pessimistic approach where traders want to make money as they believe the market will not perform well. When selling a put option contract, a person also receives a premium, which allows them to enjoy some benefits upfront. These gains come in the form of premium money.

When a trader has a market disposition that is neutral to somewhat negative, this method is most useful for him. For example, when the position is first established, the transaction is referred to as a "sell/write." Later, when the short equity position starts to move in the desired direction, one might sell covered puts.

Unlike call options, put options allow the contract holder to sell the asset at a predetermined price. A similar trade employing puts would need selling short stocks and a downside. However, this is unusual. Traders may instead deploy a married put, in which an investor with a long position in a share acquires a put option on the exact share to hedge against a decline in the share's price.

If a person is looking to short it, one may pair a short stock position with a short put position in a covered put. This allows the individual to maximize their potential profit from the trade in the form of the premium obtained from trading the put. However, it also restricts the possible profit that a person may get from a short position. If the stock falls to a lower price than the put's strike price, the person will have to exercise their option to buy the stocks and then close out their short position.

Risks

This high-risk strategy is not advised for most investors since it offers extremely limited returns, can involve an endless amount of risk and is fraught with the typical issues associated with selling stock short. In addition, it isn't easy to sell a deep-in-the-money put option at its inherent value because of the practical considerations involved. Therefore, this approach is presented more as an intellectual exercise to explore the implications of the cost of carrying than as a strategy suited for the normal investor because it is more difficult to grasp.

In a covered put strategy, expiry risk exists. However, there is a danger that late-breaking news may prevent the option from being exercised, resulting in the share's steep Monday increase. This technique is vulnerable to a strong spike in the stock, not only during expiration.

Once a trader writes an option, assignment risk is there. As assignment entails liquidating the investor's investment, early exercise signifies that no more income is received from the technique.

Example

The following is an illustration of a covered put transaction. Let's suppose a trader does the following transaction:

Short sell 500 shares of ABC for $85 and

Sell 5 ABC 80 puts @ 5

The above graph depicts that the price at which there is breakeven, no profit-no loss is $90.

The maximum profit that may be made is $3,500.

This is calculated as follows:

= $1000 + $2500

= $3500

Over $90, investors will start incurring losses.

Thus, this technique may be used if an investor is confident that the price of ABC wouldn't drop to less than $80 by the time the option expires. If shares of ABC were to drop below $80, the profit potential of the short stock would be greater. Conversely, losses have the potential to be endless if the stock price continues to rise.

Covered Put vs Covered Call

The covered put deals with put options. Covered calls deal with call options.
A covered put is a bearish strategy, whereas a Covered Call is a bullish strategy.
Covered put refers to writing an option against a short position, a borrowed and sold stock. While writing a covered call entails selling the right to purchase a share trader's own.

Covered Put vs Cash Secured Put

A covered put is used when the trader has bearish market sentiment. A cash-secured put is often used when the objective is to acquire shares at a reduced price.
A covered put is a strategy that involves shorting a stock (borrowed from a broker and sold). Additionally, a put option is sold on the same underlying asset. For example, in cash secured put, a put option is sold against a stock or exchange-traded fund underlying.
In covered put, no cash is deposited in the brokerage account. In contrast, in cash-secured put, the deal is "secured" by depositing sufficient funds in a brokerage account to pay for a prospective future stock transaction.

Frequently Asked Questions (FAQs)

How to sell covered puts?

Traders who want to sell covered puts want their shares back. The put option can be exercised by selling the underlying shares at the strike price. Or, the holder may sell the put option to the other bidder at fair market value ahead of the option's expiry. As the stock price might climb indefinitely, the maximum risk associated with selling covered options is incalculable.

What is a cash covered put?

Cash covered put is a two-part technique that entails selling an out-of-the-money put option while simultaneously leaving aside the capital required to purchase the underlying share at the option's strike price. The goal of the cash-covered put is to profit from price fluctuations in the underlying stock.

What are covered calls and puts?

Selling covered puts upon a short equity position establishes an obligation for traders to purchase the shares back at the put option's strike price. Writing a covered call includes selling the right to purchase a share that the trader already owns to another party. Selling covered puts generates this commitment.