Covered Put
(Hedge Strategy)

The covered put is sometimes viewed as a bearish version of the covered call strategy. But the trade is actually a way to enhance a short stock position. It also provides limited hedging protection.

How the Covered Put Works

covered put option strategy - enhancing a short stock position

The covered put strategy goes like this:

You begin by shorting 100 shares of a stock, and then sell, or write, 1 out of the money (OTM) put on that stock.

The premium received effectively increases the cost basis of your shorted stock position. That's good - the higher your cost basis, the more money you make if the stock falls.

The drawback is that the strike price of the put option caps your potential gains - you won't be able to benefit from any moves below the strike price.

Analyzing the Covered Put

Although in some ways this strategy resembles a covered call in reverse (for neutral to slightly bearish outlooks on stocks and markets rather than neutral to slightly bullish), that's actually an unnecessarily risky strategy. Bear call spreads are more effective and less risky if you want to trade on a neutral to slightly bearish outlook.

What you're actually doing here is increasing your cost basis on your short position, not using a short position to generate income.

The trade off for giving yourself this little boost is that you set a limit to your potential profits (see example below).

If you expect the stock to struggle and to slowly drift downward, the covered put strategy might be worth considering. If, however, you think the stock could collapse in the near term, or that it will eventually go to zero, the covered put strategy is a bad choice since it caps gains.

The one nice thing about this strategy is that once you set up the trade, you can never lose money on the option part of the trade:

If the stock falls and trades below the strike price, you simply close everything out or wait to be assigned and have everything close out automatically. Your profit is the difference between the original price that you shorted the stock plus the premium received for selling the put minus strike price.
And if the stock rallies and moves sharply higher, your short put is quickly on its way to expiring worthless. You do stand to lose a lot of money if the stock moves sharply higher, of course - but it's from the short stock position, not the option portion. The covered put option itself will never hurt you. If only everyone on Wall Street were so well behaved.

Covered Put Example

Our fictional XYZ Zipper Company is experiencing some rocky times:

Gross operating margins are declining due to rising commodity prices (what exactly are zippers made from anyway? Copper? Nickel? Zinc?).
The company's recent acquisition of Hookers, a leading suspender manufacturer which formerly traded on the pink sheets under the ticker symbol STRMP has been plagued with problems.
And now there's word of a recall of the company's ambitious but ill-advised specialty Oversized Zipper. The zippers tend to malfunction if zipped or unzipped too quickly. Anecdotal reports of some of the malfunctions have been rather gruesome. A class action lawsuit is almost a certainty.

The company has bounced back from controversy and poor performance in the past, and you believe that in the long term, the company will probably do well.

You're impressed, in any case, by the company's sheer presence in the market place. It seems that every time you visit an options education site, you're reading something about ol' XYZ.

But in the short term, things are a mess.

The stock has already fallen from $45/share down to $35/share, and you believe there's more selling pressure to come.

You short 100 shares at $35 and (excluding commissions here and throughout) you receive $3500 in your brokerage account.

You then sell to open a $30 put with an expiration date two months out and a $1/contract, or $100.

You now have $3600 in your brokerage account.

The covered put has increased your cost basis from $35 to $36, in effect giving you a bit of a head start or cushion, depending on how you view it.

Now let's look at some possible outcomes on expiration day:

The stock remains completely flat - The increase in the cost basis gives you a nice $100 return that you otherwise wouldn't have had. Congratulations. Now you have to re-evaluate your view on the stock and determine whether to buy back the stock and close the position or to sell another OTM put.
The stock continues down gradually and finally trades @ $30 a share - The perfect outcome for this trade. You've gotten unrealized gains of $5 a share plus realized another $1/share in premium now that the covered put has expired worthless. You can either buy back your shorted stock or maintain the position and sell another OTM put, this time with an even lower strike price, say $25.
The stock plummets to $20/share - You congratulate yourself on your ability to smell blood, but kick yourself for selling the covered put. You could've been up $1500 (original short price of $35/share less the current $20/share). Instead, you have to settle for a $600 profit ($36/share adjusted cost basis less the $30 strike price of the covered put).
The stock increases moderately - Against all odds, the stock shows resiliency and actually rises a bit. The covered put now functions as a limited hedge. Instead of showing a loss as the stock trades above $35/share, you won't actually be in the red until the stock crosses the $36/share.
The stock rockets ahead - Demand for zippers in the developing world has emerged as a new growth catalyst for the XYZ Zipper Company. Good times are back in Zipperland! Well, not for you. The stock has shot up to $50/share.
If you've kept the position open, here's what you're looking at - a big $%#%$ loss of $1400. Without the covered put, your loss would've been $1500. Suddenly, that $1 premium you initially received on the put seems a little thin. It's like using a parka as a bullet-proof vest. Theoretically it provides better protection than a windbreaker, but the net result is essentially the same.

Covered Put Variations

#1. You could always sell the covered put at a strike price at the money (ATM) or near the money. That would give you substantially less profit potential if the stock moved down, but more income and slightly more protection against the stock moving to the upside. But, all in all, this variation would be a fairly dumb strategy. You have even less potential profit and still relatively light protection and a whole lot of unlimited potential losses.

#2. If you have your heart set on using the covered put strategy as a neutral-to-bearish counterpart to the covered call strategy, your safest bet is to sell an ITM put instead of an OTM put. The only profit potential is the income received from the premium. But this approach can give you significantly more protection on the upside.

A quick example:

You short XYZ @ $35/share and then sell a $40 put with two months until expiration for a premium of $6 ($5 intrinsic value + $1 time value). The easiest way to track the possible outcomes is to think of it this way:

You've received $4100 in your brokerage account. As long as the stock trades @ $40 or below, you'll be obligated to shell out $4000 in two months. You make $100 as long as the stock trades at or below $40/share.

Even if the stock goes down all the way to zero, you only make $100. But of course, with that extra pad of $5 in share price between the strike price and the price that you shorted the stock, you've got a much better chance of making your small profit.

In this example (and this is only an example - actual premium amounts will obviously differ depending on the stock, options cycle, and other conditions), you won't actually lose money unless the stock trades above $41/share. With the premium factored in, that's a $6/share buffer.

If you've effectively chosen a sucky stock to begin with, you should rarely lose money. But you'll never make a lot of money either.

The inherent risk of shorting stock is arguably offset by the potential of a large payoff if and when the stock makes a dramatic move to the downside. Of course, with this variation, you've reduced some of the risk while eliminating all potential profits outside of the time value premium.

Only you can decide if this is an appealing strategy for you.