BAJAJ BROKING
February 19, 2025
5 mins read
A Covered Put strategy is a neutral to bearish market option strategy. A covered put strategy is mostly used when traders expect the price of a stock or index to either decline or remain within a narrow range. This strategy is put to work by first selling or shorting a stock or index on the bet that its price will drop. Traders, at the same time, also sell a put option on the same stock or index. If the bed goes the right way and the stock price falls, traders benefit from the short position. If not then the traders still get to keep the premium from selling the put.
As already stated, a covered put strategy is a bearish strategy. This means that when using the strategy, traders expect the stock price to drop. The profits earned as a part of this strategy happen when the stock prices decline. This is why the best time to use it is when there is a negative outlook on the stock’s future movement. When traders are confident that the price will drop, using a Covered Put can turn out to be profitable.
Let us take for example a stock that a trader might have eyes on for a while in the hopes that its price will drop. Being sure about this occurrence, they decide to short the stock in the hopes that they can later buy it back at a lower price. However, what if after the shorting the trader starts having second thoughts? To help manage any potential risks in this, traders can sell a put option on the same stock, that has a strike price lower than their short entry. As a seller, the trader will receive a premium for the put option that can offset any losses that they might incur from the shorted option.
Here are three different scenarios that you can look at in this context:
Scenario 1: The price of the stock declines
Once the trader has shorted the stock, profit is generated as its price declines. They also add to their profit by selling the put option. Here, their total profit will come to:
(Short entry price – Put strike price) + Premium received.
Scenario 2: The price of the stock rises
In cases where the stock moves against the trader’s expectations, they will incur a loss. This is where the premium they received from selling the put helps offset some of the loss. In such cases the loss incurred:
(Current stock price – Short entry price) – Premium received.
Scenario 3: The price of the stock remains the same
When the stock price doesn’t move, the trader’s short position sees no gain or loss. The good news here is that the trader still has the premium they received from selling the put option and that is what their profit is in this deal.
Any trader who is considering using a covered put strategy means that they are bearish on a stock and expects that its price will decline. To ensure that the losses are negligible if the market goes in the opposite direction, they also sell or write a put option as the premium generated from that sale helps offset any potential losses from the shorted option.
The moment an investor shorts a stock, they profit if the price drops. But if the stock prices rise, they could face losses. This is where the premium collected acts as a small cushion in case the trade doesn’t go as planned.
When the stock price is above the strike price, the put option expires worthless, and the investor keeps the premium. When the stock price falls below the strike price, then the put option is in the money and gets exercised. Apart from this, since the investor holds a short stock position already, they will profit from the stock’s decline.
With the help of a covered put, bearish investors can generate extra profits even as they are shorting a stock.
Listed below are some of the advantages of using a covered put strategy:
When a put option is deep in the money, the maximum profit a trader can make is limited to the interest earned on the initial cash and the time value or extrinsic value that is left in the option when you sell it.
In such a strategy, the ideal situation is when the stock price stays below the strike price throughout. What this leads to is the exercising of the option before expiration and the liquidation of the trader’s position which locks in the profit.
The stock profit or loss in a covered put strategy can be calculated by subtracting the purchase price from the sale price. Here the purchase price is the difference between the short sale price and the put strike price.
Add to this the premium the trader received for selling the option and any earned on cash.
Some of the disadvantages of the covered put strategy are listed below:
When an investor writes an option and they end up exercising it early, then it means that they do not receive any further interest.
It is also important to keep in mind that if the stock is involved in events like a merger or a special dividend, any expectations regarding early option execution will not work.
The risk of the expiration of the option also exists in a covered put strategy. Suppose the execution of the option is prevented by late news that can potentially result in a significant increase in the stock, then also the strategy could face a threat.
As far as trading strategies go, shorting a stock might just be one of the riskiest ones out there. This is because unlike buying a stock where the maximum amount you can lose is the one you invested, shorting holds the potential of unlimited losses if a stock's price keeps rising.
This is why, it is of utmost importance that before deciding to use the strategy, you guage all the pros and cons associated with it, especially when it holds the potential for unlimited losses.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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This strategy is put to work by first selling or shorting a stock or index on the bet that its price will drop. Traders, at the same time, also sell a put option on the same stock or index. If the bed goes the right way and the stock price falls, traders benefit from the short position.
The covered put strategy is risky and this is why you must gauge all the pros and cons of it before using it.
In a covered put strategy, the investor can generate profits either way in the form of an additional premium, that acts as a cushion to offset the losses from the rise in stock prices.
Selling covered calls means owning a stock and selling call options on it to earn premium income. This strategy limits upside potential but provides downside protection through collected premiums.
A covered strangle is an options strategy combining a covered call and a cash-secured put, aiming to generate premium income while managing risk in a neutral-to-bullish market scenario.
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