Investing in the equity market is not the only way to make money. There’s a whole other segment – the derivatives segment that can also be used by investors and traders alike to generate profits. However, the derivatives segment, more specifically options, can be quite tricky to navigate due to the higher levels of risk involved. That said, there are plenty of strategies that you can utilize to ensure that you don’t end up with a loss. The covered put is one such strategy that traders and investors use frequently. Here’s everything you need to know about the covered put option strategy.
What is a covered put?
If you’re familiar with the covered call, then the covered put is quite similar to it except that it deals with put options rather than call options.
Technically, the covered put strategy requires you to sell a put option contract of the stock that you’ve shorted. By selling a put option, you basically limit your profits by locking in the price of the asset. Also, you get to enjoy a bit of gains upfront through the premium that you receive when you sell the put option contract. Furthermore, you’re also protected to a slight extent from unexpected stock price increases.
When should you use the covered put?
The covered put strategy is bearish in nature since you’re shorting a stock expecting the price of the asset to fall and simultaneously selling a put option for some short-term profits. Considering the nature of this strategy, it should be used only when you have a negative outlook on the future stock price movement.
How does the covered put option strategy work?
For example, let’s assume that you’ve been eying the stock of a company for quite some time. You have a negative outlook and strongly believe that the stock price would decline in the future. And so, you initiate a short position on the stock, hoping to buy it back once the price falls.
But then, after you shorted the stock, you’re now not very sure whether the stock price would decline much and believe that the downside would be limited. What do you do in this case?
Here’s where put option contracts come to the rescue. You can sell a put option contract of the same stock for a strike price that’s lower than the price at which you shorted the stock. Since you’re the seller of the option here, you’d also be entitled to receive a premium from the buyer, which you get to retain irrespective of whether the option is exercised or not.
Now that you’ve shorted the stock and sold a put options contract, here’s what your position would look like under three different scenarios. Let’s take them up one after the other to understand the impact of the covered put.
Scenario 1: The price of the stock declines
In this scenario, a short-term profit is guaranteed to you since you’ve effectively locked in the price at which you would buy the shares by selling a put option. Additionally, you would receive a premium from the buyer of the put option as well. So, your net gain here would be the difference between the short stock price and the put strike price plus the premium received from the sale of the put option.
Scenario 2: The price of the stock rises
Here, since the price of the stock moved against your expectations, you would make a loss on your trade. Your loss here would be the difference between the price at which the stock is currently trading and the short stock price. However, since you still get to keep the premium from the sale of the put option, it can be used to reduce the amount of loss that you had to suffer.
Scenario 3: The price of the stock remains the same
When the stock price remains the same, you neither make any gains or any losses from your short position. But then, the premium that you received from the sale of the put option would still be with you. This is the amount of profit that you would then get to enjoy from this trade.
One of the riskiest moves in the investing and trading world is the shorting of a stock. This is primarily due to the fact that when you take a short position, the maximum amount of loss that you can suffer becomes unlimited since there’s virtually no cap on how much the stock can rise. And so, it is advisable to calculate your moves accurately before deploying a covered put strategy due to the theoretically unlimited loss component.