could someone explain covered puts in simple terms?

Options Trading Fundamentals & Education
1

I see covered puts mentioned a lot but I still don’t get how they work.

I know about regular puts but the covered part is confusing. Articles I found are too technical.

Can someone explain it in simple terms? What makes it covered and when should I use this strategy?

2

The Problem:

You’re trying to understand covered put options and how they work, but you’re unsure about the mechanics and potential risks involved. You’ve potentially experienced losses due to a lack of complete understanding.

:thinking: Understanding the “Why” (The Root Cause):

A covered put is an options trading strategy where you simultaneously sell a put option and own the underlying shares of the stock. This strategy is often employed when you believe the stock price will either remain stable or decline slightly within a specific timeframe. The primary reason for executing a covered put is to generate income from the option premium received from selling the put.

The “covered” aspect refers to the fact that you already possess the shares needed to fulfill your obligation if the put option is exercised. If the put option buyer exercises their right to sell you their shares at the strike price, you’re already prepared to accept them because you already own those shares. This reduces some of the risk compared to selling a naked put, where you don’t own the underlying asset. However, it’s not without risk.

:gear: Step-by-Step Guide:

Step 1: Understanding the Mechanics:

  1. Own the Underlying Stock: Before selling a covered put, you must already own the shares of the stock you’re selling the put on. The number of shares owned must match the number of contracts you’re selling (1 contract = 100 shares).

  2. Sell the Put Option: Locate a put option contract for the stock you own with an appropriate strike price and expiration date that aligns with your outlook on the stock price movement. Sell this contract. You’ll receive a premium payment for doing this.

  3. Potential Outcomes:

    • Stock Price Stays Above Strike Price: If the stock price remains above the strike price at expiration, the put option expires worthless, and you keep the premium you received. This is the most desirable outcome.
    • Stock Price Falls Below Strike Price: If the stock price falls below the strike price at expiration, the put option will likely be exercised. This means the option buyer will sell you their shares at the strike price. You’re already covered as you own the shares, therefore you simply fulfill the obligation to purchase. The net profit/loss will be the premium earned minus any decrease in the stock price.

Step 2: Risk Assessment and Mitigation:

The primary risk with a covered put is that the stock price could rise significantly above the strike price before expiration. This reduces the profit potential of your covered put because you’re holding a stock that’s now worth more than you originally anticipated. The upside is limited by your original stock purchase price. Your potential losses will be limited to the difference between your initial stock purchase price and the market price at the time of purchase, less the premium received.

To mitigate risk:

  • Thorough Stock Research: Conduct thorough research on the underlying stock and its outlook before entering a covered put trade.
  • Choose Appropriate Strike Price and Expiration Date: Select a strike price that offers a reasonable premium but still maintains a relatively low risk. A shorter expiration date increases the premium but also increases risk due to less time for the stock price to move favorably.
  • Diversify Your Portfolio: Don’t put all your eggs in one basket. Diversifying across multiple assets helps reduce the impact of losses on any single investment.

:mag: Common Pitfalls & What to Check Next:

  • Misunderstanding the Risk: While the risk is limited compared to a naked put, it’s not eliminated. Be aware of the potential for losses if the stock price moves against you, especially around earnings announcements which tend to increase volatility.
  • Overestimating Premium: Don’t overestimate the premium you’ll receive. The premium is dependent on various factors, including the volatility of the underlying stock, time until expiration, and the distance between the strike price and the current stock price.
  • Ignoring Time Decay: Options lose value over time (theta decay). The closer the option gets to expiration, the faster the decay. Consider this when choosing your expiration date.

:speech_balloon: Still running into issues? Share your (sanitized) config files, the exact command you ran, and any other relevant details. The community is here to help!

3

I lost $800 on my first covered put. I didn’t fully understand the risk involved.

You short shares and sell a put option at the same time. If the put is assigned, those borrowed shares cover your obligation.

I thought I was making easy money, but the stock surged 40% and wiped out my position.

4

Covered puts involve selling a put option while owning the stock. It lowers risk.

5

A covered put means you’re short the stock while selling a put option. You borrow shares, sell them, and then sell the put. If the put gets assigned, your short position covers your obligation. This strategy works best if you expect the stock to move down or stay flat. You earn the premium from the put sale, but your profits are limited. The main risk is if the stock price rises; you could lose money on your short position and deal with the put assignment. It’s a strategy that carries significant risk.

6

Shorting stock plus selling a put equals synthetic covered put. Maximum profit is strike minus short price plus premium. Risk increases if stock price rises; short losses are unlimited.