Understanding
Stock Options Trading
and Technical Analysis Basics

Selling Covered Put Options

Selling Covered Put options is a bearish strategy that is mechanically similar to the Covered Call, but is dramatically different in both profit and risk profile. While the Covered Call is a very conservative strategy meant to generate monthly income on stocks that have either a flat or slightly upbeat forecast, the Covered Put is a very high-risk strategy used for stocks that are likely to fall in price.

The Covered Put is created by initiating two positions: shorting the underlying stock and selling the related put option at the closest strike price. Since you are shorting the underlying stock, this strategy is considered very high risk, and you might be out of pocket by a lot if the stock goes up in price and you need to buy it back. Strategies involving shorting stocks is usually performed by day traders and those trading on margin, and can be considered advanced strategies that require experience and caution.

Covered Put individual components

Covered Put composite

Easy-speak A Covered Put is a high risk strategy that is used for stocks that are expected to drop in price. It is created by shorting the underlying stock and selling its associated put option.

The Covered Put is a credit position, in that initiating the trade will provide you with an initial payout. You will get initial income from shorting the underlying stock, as well as from selling or writing the associated put option. Closing the trade will require you to buy back the underlying stock (which will hopefully be cheaper than what you shorted it for). If the stock price is above the put option's strike price, you can let it expire worthless. However, if the stock price is below the option's strike price, you will need to buy the option back.

As can be seen from the diagrams above, the Covered Put produces a profit profile that favors the stock price going down. Shorting the underlying stock means that if the price of the stock goes up, you will incur unlimited losses which will go up the higher the stock price climbs. But this also means that the more the stock price falls, the more you earn. Selling the associated put option has three effects on this trade. Firstly, it pushes the breakeven point higher. This gives you a larger margin of error, that is the stock price can climb higher before you start to incur losses. Secondly, selling the put option increases your profit. As long as the stock price is above the put option's strike price, your profit will be greater than if you hadn't sold the put option.

The third effect is a negative effect in that it limits your potential profit from this trade. If the stock price drops below the put option's strike price, the put option will no longer expire worthless and you will need to buy it back. If the stock price falls lower, the gains from shorting the underlying stock will match and cancel out the loss incurred from buying back the put option. This effectively means that your profit is capped once the stock price goes below the put option's strike price.

The Covered Put strategy is a very different beast compared to other bearish strategies such as the Put Backspread or Short Synthetic, or even simple trades such as buying a basic put option. It is a credit position which does not require an initial outlay, and actually comes with a huge initial credit surplus. You will also start seeing profit at a higher breakeven point. However, this comes with the risk of the stock price going up and causing huge losses.

Easy-speak The Covered Put is a credit position providing initial income. You can earn a capped profit if the stock price falls, but can incur unlimited losses if the stock price rises.


Other Topics in this Guide

Bullish Strategies Bearish Strategies Neutral Non-Volatile Strategies Neutral Volatile Strategies

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