What is Covered Put?
There are many ways to earn profits from the movement in a stock’s price apart from buying the actual stock. For example, options trading allows you to exercise a wide range of strategies. So it is because of the different ways in which you can combine the buying and selling of call options and put options at different strike prices and expirations.
The covered put and covered call are options trading strategies that investors and traders use frequently. This article teaches you everything about the covered put option strategy.
Covered Put Defination
The covered put or married put option strategy is used when the trader anticipates a moderately bearish market. It is used to reduce the cost of a short position. When the trader expects a fall in the price of the underlying, the trader holds a short position. Then, on the same underlying asset, the trader writes a put position to gain profits. However, if the stock price rises substantially, the trader will have to incur heavy losses.
The profit a trader can earn by using this strategy is capped. The maximum profit one can earn is limited to the premiums received. A trader starts earning profits when the price of the underlying security reaches higher than the strike price of the Short Put.
The risk involved is unlimited. The risk of losses is directly proportional to the price of the underlying. With a rise in the price, the risk factor also increases.
A trader must use the strategy only when there is a surety that the stock price will remain constant or fall. So, the covered put option strategy is ideal for stocks showing a downward movement.
When Should One Use the Covered Put Strategy?
The right time to use the covered or married put strategy is when the trader anticipates a neutral or moderately bearish market. If you expect a downward movement in the price of the stock, you can use the strategy to generate profit. However, do not practice the strategy when there are chances of a price rise, as it can lead to huge losses.
The strategy helps earn profits when the price falls. However, the premium you receive on the put option can reduce the loss suffered or maximise your profits. So while the profit you can earn is not significant, you continue to earn profits as the stock’s price reduces.
In the covered put option strategy, the chances of risk are unlimited. If the price of the stock moves in the direction opposite to what the trader had expected, there will be huge losses. Since there is no maximum price of the underlying stock, you cannot cap the maximum loss.
How Does the Covered Put Option Strategy Work?
As mentioned earlier, the covered put performs well in a moderately bearish market. Let us understand this with the help of an example.
Suppose you are monitoring the performance of a company’s stock for a while. You feel that its price will decline in the future. You decide to create a short position with the plan to buy it back after the price falls. But you are not sure about the degree of fall and feel that the downside will be limited. Therefore, you use a put options contract.
- The stock price falls.
If the stock price declines as anticipated, you earn a short-term profit. The premium you receive on selling the put option is with you. So, your total profit is short stock price minus put strike price, along with the premium earned.
- The stock price increases.
If the stock price rises, you will incur a loss. To calculate the loss, subtract the short stock price from the current stock price. The premium you receive from selling the put option is with you, and you can use it to compensate for the loss.
- The stock price remains constant.
If there is no change in the stock price, you do not earn any profits or incur any losses. However, you will still have the premium you received for selling the put option.put option.
Also Read: How to Earn Profit from the Share Market
In A Nutshell
In the journey of investing and trading, shorting a stock is quite a risky move. It is so because when you take a short position, the maximum amount of loss you can suffer is unlimited. There is almost no cap on the price to which the stock can rise. Therefore, one must use the covered put strategy cautiously since there is a potential of unlimited losses while the profits are capped. The strategy is suitable for experienced traders who are convinced about a little fall in the prices of the underlying asset.
Also Read about Covered Call in Option Trading
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Frequently Asked Questions
An investor must use this type of put option strategy if they are of the view that the markets are moderately bearish.
Yes. A trader may have to face unlimited risk if the stock price increases steeply.
A covered put is a bearish strategy. It is quite similar to the covered call. The difference is that covered call deals with call options while covered put deals with put options. In the covered put option strategy, you need to sell a put option contract of the stock you’ve shorted.
The covered put or married put strategy is an income generation strategy in the neutral or bearish market. It can also help in reducing the losses by the amount of premium received.
Generally, the objective of covered call and put positions are to protect the losses and reduce the cost of the option strategy. The goal isn’t earning profits. However, in certain cases, the strategies do result in profit generation.
Yes. But, you must know your position clearly on a net basis. Applying very complex strategies can be too confusing and expensive.