Stock traders use combinations of options contracts and other securities to limit risk and/or increase the profit potential of trades. Writing covered puts combines two transactions: selling a stock short and writing put options for an equal number of shares at the same time. A stock trader is likely to use a covered put to protect against a slight increase in price when shorting a stock and to increase profit on the short sale. A covered put is most useful when you do not expect a large upward or downward movement in the stock price in the near term.
1. Sell shares of the stock short at the current market price. Let’s say you sell 100 shares of XY stock short at a price of $26 per share. Selling short means you agree to sell shares of a stock you do not own at the current market price -- usually to your broker. At a future time, you must buy the shares to complete the short sale. In this example, your broker must buy the shares from you at $26 per share regardless of the market price at the time you buy and deliver the shares.
2. Write a put option for shares of the stock with a strike price that is close to but less than the current market price. When you “write” a put option, it means you sell a put option contract that gives the purchaser the right to sell shares to you at a guaranteed “strike” price. The holder of the contract does not have to exercise the option, but if she does, you are obligated to buy the shares. In the example above, you would write a put option for 100 shares of XY stock with a strike price of $25 per share. When you write an option, you collect a premium. For this example, assume the premium is $1 per share.
3. Close out the short sale after the put option you wrote expires if the market price of the stock does not fall below the strike price. The buyer of the put option will let it expire in this situation because he cannot buy the shares for less than the strike price and then exercise the option by selling them to you at a profit. When you buy shares on the market to complete the short sale, the broker must pay you $26 per share. You also collected a $1 per share premium, so you receive a total of $27 per share. If the market price you pay for the shares you need to complete the short sale is less than $27 per share, you make a profit. If the market price is more, you take a loss on the covered put trade.
4. Buy the shares called for by the put option if the owner of the option contract exercises it. This will happen if the market price falls below the strike price. Use the shares you bought to complete the short sale. In our example, you pay the strike price of $25 per share for the stock when the put option is exercised. Your broker pays you $26 per share, plus you have the $1 premium, for a total of $27 per share. Your profit is thus $27 per share minus the $25 per share strike price, or $2 per share.
- A covered put provides limited profit potential. However, the potential loss is unlimited if the stock price goes up by a large amount. This is because you have to buy the stock at some point to close out the short sale, regardless of the price you have to pay.
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