Covered puts are primarily used by investors looking to generate income on short portfolio holdings while reducing the position’s cost basis.
Because options are leveraged, each contract represents 100 shares of stock, so a covered put requires a short position of at least 100 shares of the underlying asset. The short shares of stock can be sold before selling the covered put, or the positions can be entered simultaneously by short selling the shares and selling the covered put against the stock position.
A covered put strategy is used if an investor is moderately bearish and plans to hold short shares of stock in an asset for an extended length of time. The covered put will help generate income during the holding period and lowers the original position’s cost basis.
A covered put consists of selling a put against shares of short stock. Typically, covered puts are sold out-of-the-money below the current price of the underlying asset. Puts sold closer to the stock’s current price will result in more credit received but have a higher probability of being in-the-money at expiration.
Covered puts do not eliminate downside risk if the asset rises in price, but every covered put sold adds credit to the account, thereby reducing the overall cost of holding the short stock position.
Selling a covered put does not eliminate downside risk. However, it does help to reduce it by the price of the premium received.
For example, if a stock is sold at $100 and a put option is sold at the $95 strike price for $5.00, the original position’s cost is now reduced by $5.00. Therefore, the cost basis and break-even point of the short stock position is now $105.
If the stock rises above that price, the downside risk is unlimited, minus the adjusted cost basis. If the short put option is in-the-money at expiration and assigned, the profit potential is limited to the option’s strike price plus the premium collected from selling the put option. The option seller is obligated to buy shares of stock at the short strike price if assigned, therefore closing the short stock position.
If the stock closes below $95 at expiration, a profit of $1,000 will be realized per contract, because the stock profited $5.00 per share ($500), plus the credit received from selling the covered put option ($500). If the stock closes above the short put at expiration, the option will expire worthless, and the credit received will remain.
A covered put requires the writer to be short at least 100 shares of stock. If short stock is already borrowed, a put option may be sold at a lower strike price than the current stock price. A covered put can also be sold at the time the stock is sold.
There are two scenarios for exiting a covered put at expiration, depending on where the stock price is relative to the strike price of the put option sold. If the stock price is above the strike price at expiration, the put option will expire worthless and the option premium collected is the amount profited from the trade. At this point, a new covered put position may be initiated for a future expiration date.
If the stock price is below the strike price of the short put option at expiration, the short stock is “put” to the option seller at the strike price. If the short put option is in-the-money at expiration, but the investor does not want to exit the position, the trade can be rolled out to a later expiration date by buying back the short put and selling a new contract.
Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. Short put option contracts with more time until expiration will have higher prices because there is more time for the underlying asset to experience price movement. As the time until expiration decreases, the price of the put option goes down.
Covered puts with longer-dated expirations will collect more premium when the trade is entered than those with shorter time duration. Time decay, or Theta, works in favor of the covered put writer.
Implied volatility reflects the possibility of future price movements. Higher implied volatility results in a higher price of short put options because there is an expectation the price will move more in the future. Selling covered puts with higher implied volatility will receive more credit at trade entry, but the underlying asset is expected to have more price fluctuations.
There are multiple ways to adjust a covered put position if the underlying asset’s price moves up or down before expiration. A covered put is either in-the-money or out-of-the-money at expiration, and adjustments can be made to address each scenario.
If the stock is below the short put strike price at expiration, a decision will need to be made. If no action is taken, the short put will be exercised and the broker will automatically buy 100 shares of stock per option contract at the option’s strike price. The stockholder will experience the gains of the move down in the underlying stock and keep the credit from selling the short put. Any move below the strike price will not be included. If the covered put writer does not wish to exercise, the put option can be rolled out to the next expiration month.
If the underlying price has moved sideways or up before expiration, and the stock price stays above the short put, the original covered put will expire worthless. At this point, a new position may be opened for a future expiration date at the same strike price or a higher strike price. Any credit received from selling the put option will remain.
The closer to the money the new put option is sold, the greater the credit received, but the more likely the short stock position may become in-the-money and subject to assignment at expiration. It should be noted that most assignments do not occur until the last week of expiration.
Covered puts can be rolled up or down before expiration. The short put option can be rolled up to a higher strike price within the same expiration month if the underlying asset has traded sideways or gone up in price. A strike price closer to the stock price will result in more credit received but have a higher probability of being in-the-money at expiration.
Suppose the stock has moved below the strike price and the investor wishes to continue to hold short the underlying stock and does not want the position put to them. In that case, the short put option can be repurchased and a new contract sold for a later expiration with the same strike price or a different strike price.
Covered puts can be hedged by rolling up the short put option as price increases. To roll up the option, repurchase the short put (for less money than it was sold) and resell a put option closer to the stock price. This will limit the upside potential but the credit received for the roll will help offset the upward movement of the stock.
Another strategy to consider is to purchase a long call option with a strike price above the short put option’s strike price. Long call options give the holder the right to buy shares of stock at the strike price. For example, if short stock is sold at $50 and a covered put is sold at $45, a long call option could be purchased at $55 and guarantee the opportunity to buy stock at $55. Buying the call option will cost money and therefore offset some or all of the credit received for selling the covered put.