A covered put is a trading strategy in which the trader shortens the underlying option and sells the same number of put options. In this way, the trader is able to make more profit in the form of a premium for writing the put option.
This is done by taking a short position on a stock and combining it with writing the put option on the same stock. Writing the put options provides the strategy with a net credit. If the price of the stock at the time of expiration is more than the strike price of the put option the option expires worthlessly. But if the stock price is more than the put strike price, then purchase the option back.
This option is used at the time when the trader is neutral or slightly bearish towards the market and is expecting the price to move down to some extent. In this situation holding a short position on underlying trader can also write a put option on the same underlying and earns a profit. The risk here is that if the price of the underlying goes up the trader will incur massive losses.
The covered put strategy of trading has unlimited risk and limited profit. The profit made is limited to the premium received on writing the put option. This risk here keeps on increasing as the price of the underlying rises up. So use the strategy only when the trader is certain that the prices will either remain stable or go down. Bullish stocks are highly incompatible and neutral or slightly falling stocks are compatible with this strategy.
Covered Put Timing
The appropriate time to use this strategy is when the trader is neutral or slightly bearish. The trader is expecting the prices of the underlying to go down slightly and is waiting to make a profit. The most unsuitable time to use this strategy is when the prices of the security will go up. The covered put strategy allows the trader to make a profit when stock prices go down.
This strategy moves the breakeven point higher and gives a bigger margin of error. Before the trader starts incurring losses the stock prices will have to move higher than the amount of premium received. The profit on writing the put option helps to compensate a part of the loss or may increase the profit by the same amount.
The covered put strategy has a limited profit scope. Even in the absence of the covered put strategy, the trader can keep earning profit as the price of the underlying keeps on decreasing.
Covered but has an unlimited risk profile, as the price of the underlying stock increases the strategy will incur losses. Since there is no limit on the price of the underlying there will be no upper limit to the losses also. The premium will also be not enough to balance the losses.
Advantages
- The strategy carries a net credit and generates income in the form of a premium.
- The covered helps in reducing losses through the premium.
Disadvantages
The strategy has unlimited risk and may lead to huge losses if the cost of the underlying increases.