Covered Put Explained
Traders that use the Covered Put strategy will receive the initial credit from shorting the stock, as well as the option premium from selling the associated put option. In this way you are increasing your probability of profit.
A covered put strategy becomes profitable when the associated option expire with the market stock price below the credit received above the initial short stock price. The underlying can go up a little bit (the credit received), stay the same, or go down and the trade will be profitable.
Calculating max profit
Max profit occurs when the options expire with the underlying at or below the short put’s strike price. To calculate the trade’s max profit, take the short stock price minus the short put’s strike price plus the credit received for selling the put.
The moment you want to close the trade you need to buy the underlying stock back.
Your aim is to buy it back cheaper than the price you have shorted it for. If the stock price is above the put option’s strike price, you can let it expire worthless. However, if the stock price is below the option’s strike price, you will need to buy the option back.
As can be seen from the diagram, the Covered Put produces a profit profile that favors the stock price going down. Shorting the underlying stock means that if the price of the stock goes up, you may have loss. You will experience much more loss when the stock price climbs higher.
But this also means that the more the stock price falls, the more you earn. Selling the associated put option has three effects on this trade.
- It pushes the breakeven point higher. This gives you a larger margin of error, that is the stock price can climb higher before you start to incur losses.
- Selling the put option increases your profit. As long as the stock price is above the put option’s strike price, your profit will be greater than if you hadn’t sold the put option.
- It limits your potential profit from this trade. If the stock price drops below the put option’s strike price, the put option will no longer expire worthless and you will need to buy it back. The gains from shorting the underlying stock will match and cancel out the loss incurred from buying back the put option. This effectively means that your profit is capped once the stock price goes below the put option’s strike price.
The Covered Put strategy is a very different beast compared to other bearish strategies or even simple trades such as buying a basic put option. It is a credit position which does not require an initial outlay, and actually comes with a huge initial credit surplus. You will also start seeing profit at a higher breakeven point. However, this comes with the risk of the stock price going up and causing huge losses.
The Covered Put is a credit position providing initial income. You can earn a capped profit if the stock price falls, but can incur unlimited losses if the stock price rises.