In today's video, we want to talk about a covered put spread. Writing covered puts is a bearish options trading strategy that involves selling of an at the money or out of the money put option below the market price while shorting 100 shares of the underlying stock.
This is a capital-intensive strategy because you have to be short at least 100 shares of stocks to sell a covered put. It usually is something that requires a lot of capital to be able to short and cover those shares.
How do we set this up specifically? Well, we have to sell 100 shares of stocks, or you have to already be short 100 shares of stock. Either way, you can start out by already having 100 shares short and adding the put, or you can sell 100 shares at the same time as you add the put.
In our case, we also want to sell one out of the money put option which helps to increase the cost basis on those shares. Because you are still short 100 shares of stock, the risk in the trade is that the stock continues to rise past your breakeven point.
Selling the put option does help increase the cost basis in the shares that you shorted, but it does not protect us in case the stock continues to rally.
As far as profit potential, a covered put does have limited profit potential to the difference between the strike price and the stock price plus the credit received from selling the out of the money put.
We’ll just take a break here and just talk about this because a lot of people say that this is not necessarily a good thing to have a limited profit potential.
But as you’ll see here, increasing the cost basis on the stock increases our chance of success because now, the stock can sit right where it is, and we can make money. It can even rise a little bit in price which is against the trade, but it could rise just a little bit in price.
As long as it stays below our breakeven point, we will make money on this trade. It’s a very good way to limit your potential profit, but increase your chance of success in the trade.
As far as volatility or Vega goes, since we are short naked options and the stock is not affected by volatility, increasing implied volatility will hurt this position just like any other short option position.
Time decay though will help this position. Because we’re short the premium received on the sale of the put, we want to see the stock get closer and closer to expiration which helps that profit materialize a little bit faster.
Breakeven points are pretty easy to calculate with this type of a trade. You’re going to take the short stock price plus the credit received on the sale of the put, and that’s going to give you your new cost basis on the shares that you shorted.
Let’s go through an example here on our broker platform. What we’re going to do is we’re going to look at GLD. The reason that we’re just going to look at it is that it’s had a huge run-up recently.
For some reason, if you think that it might come back down or have a drop here any time soon, you might want to short GLD or get bearish on GLD. When we go to the Analyze tab, and we start to build this strategy, the first thing that we need to do is we need to be short 100 shares of the stock.
I’m just going to be short 100 shares of the stock. We’re just going to round up the price to about 125 here just to make it very easy as far as math goes on the video.
We’re short 100 shares of stock at 125 which is just two pennies above where the market is and then what we’re going to do is we’re going to sell an out of the money put option on the market.
In this case, we might go and do something in February which has just about 30 days to go, so this is as long as this trade will last and we’ll do something around the 123 strike which is just a couple of strikes out of the money, so it’s about $2 below where the stock is trading.
If we sell that option and combine it with this strategy, you can see that we can take in an additional 188 in premium. This 188 in premium that we take in helps increase the cost basis of the shares that we shorted.
This is what that risk profile then would look like. You can see it's very similar to what we had on the slides before. Everything is limited as far as profit potential below the short strike of 123.
That's exactly where we start to limit our profits below that point. After that, we do have an unlimited risk if the stock continues to move higher. But the benefit in doing this strategy is that…
If we zoom in here, we can see this a little bit better. But the stock is currently trading at 125 where we shorted the shares. Our breakeven point is all the way out here at 126.88.
We take the stock price here, and we add the 188 credit that we received and that gives us our new breakeven point out here at 126.88. This is why this strategy (even though it has limited profit potential) can only make about $380 on this trade.
You do have an increased chance of success because the stock can rally all the way up here and you still don't necessarily lose any money on the trade unless it goes beyond that point at expiration.
The stock can sit right here where it is, and we could make money, and obviously, it can decline, and we make money as well. This is why these strategies are so favorable to investors.
Some key takeaways here for the covered put spread. It's important to remember that should the stock move past your out of the money put strike at expiration, so continue to head lower, you will need to deliver or buy back the 100 shares that you’re short.
You either have to give those up if you’re short or you got to buy them back in the market to cover the position. We don’t favor these strategies because of such a high capital requirement in shorting the shares.
We think that you can accomplish the same thing with a short call, just a short naked call above the market or you can do something synthetically with options. We've got different video tutorials about that right here in the membership area at optionalpha.com.
As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below. Until next time, happy trading!