Randy Frederick

Managing Risk Using Options

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Covered Puts: Short Stock, Short Puts in Equal Quantity

Covered puts work essentially the same way as covered calls, except that the underlying equity position is a short stock position instead of a long stock position, and the option sold is a put rather than a call. A covered put writer typically has a neutral to slightly bearish sentiment.

Selling covered puts against a short equity position creates an obligation to buy the stock back at the strike price of the put option.

Just like with covered calls, often the best time to sell covered puts is either at the same time a short equity position is established (sell/write), or once the short equity position has begun to move in your favor.

Since the concept is similar to a covered call, we'll jump straight to an example:

Below is a graph showing a hypothetical covered put trade in which you sell short 1,000 shares of XYZ at $72, and sell 10 XYZ April 70 Puts at $2.

If we put this combined trade example on a graph, you can see that the breakeven price is $74, and the profit is capped at $4,000 for all prices below $70 ($2 x 1,000 [shares stock] + $2 x 10 [option contracts] x 100 [options multiplier]).

You can also see that even though there are two points of price protection against an increase in the stock price, losses will be incurred above $74, all the way up indefinitely. The losses could be unlimited if the stock continues to increase. In each case though, the losses would always be $2,000 less than the stock trade alone.

You would want to employ this strategy only if you thought the price of XYZ would not fall below $70 by the April expiration. If XYZ did fall below $70, the short stock trade alone would have been more profitable.