Stock Options: Covered Puts

In a covered put strategy, you are selling the underlying stock and selling a put option against it. This strategy is best implemented in a bearish to neutral market where a slow fall in the market price of the underlying stock is anticipated. This strategy's profit-making ability depends on the short options expiring worthless. Therefore, although an option with more time yields a higher premium, never sell puts in a covered put strategy with more than 45 to 60 days until expiration. Too much time increases the chance of the market price moving into a range where the short option is exercised. If a put option is exercised, the option seller is obligated to buy 100 shares of the underlying stock at the put's strike price from the option holder.

Let's create an example of a covered put strategy using Eastman Kodak Co. (EK) by going short 100 shares of EK @ 74 and short 1 January EK 70 put @ 4. For this position to keep the credit, the market price of the stock needs to stay above $70. The maximum profit for this trade is the premium received for the short put option plus the money accrued from the sale of the stock if the option is exercised. The maximum reward on the option side of this position is $400 [(4 x 100 = $400). The maximum reward on the stock side of this position is $400 [(74 - 70) x 100 = $400]. This creates a total profit of $800 (400 + 400 = $800). The maximum risk is unlimited to the upside beyond the breakeven. This trade requires a margin deposit to place. Figure 1-D shows the risk profile for this trade.

The breakeven on a covered put is calculated by adding the put option premium to the price of the underlying stock at initiation. In this example, the breakeven is 78 (74 + 4 = 78). Unfortunately, placing a covered put will not protect you from sharp rise above the breakeven. If Eastman Kodak rises above 78, the trade will start to lose money. However, selling a put against a short stock does increase the breakeven. If you were to simply the sell the stock, the breakeven would be the purchase price of the stock at initiation or 74. If Eastman Kodak falls below the strike price of the put, there is a possibility that the put will be assigned and you will be obligated to purchase the stock at the strike price. If so, you can return those shares to your brokerage to cover the short shares at the higher initial price and pocket the difference as profit.

By tracking this trade, we find that Eastman Kodak actually rose above the breakeven 2 days before expiration, only to plummet to 69 on expiration day. There is a good chance that the put received notice of assignment at which time the short stock position was closed out for a total profit on the trade of $800. Since Eastman Kodak continued in a bearish trend after the option expired, we potentially missed a bigger profit on the stock by having to use the shares to fulfill our obligations on the assigned short put. Such is life.

Covered puts enable traders to bring in some extra premium on short positions. Once again, you can keep selling a put against the short shares every month to increase your profit. However, shorting stock is a risky trade no matter how you look at it because there is no limit to how much you can lose if the price of the stock rises above the breakeven.