Selling Covered Puts
(What Do You Gain, What Do You Lose?)

Question - Covered Puts

I'm confused. What do you lose selling covered puts? And what do you gain? How much safer of an option strategy is a covered put than a naked put? I get covered calls, those are easy to grasp, but the put version isn't sinking in. Help!

Answer

Those are actually some pretty good questions since this strategy doesn't get much attention and there's frequently a lot of confusion regarding it. At first glance, you might be tempted to view it as a sort of alternative version of the covered call strategy, but if you approach the strategy from that angle, it becomes a fairly high-risk strategy.

For a full description and review, check out the covered put option strategy page.

But for the short(er) version . . .

Despite their name, these aren't really associated with either naked puts or, for that matter, covered calls.

A covered put is simply an out of the money put you write (or sell) on stock that you've already shorted.

And why would you do this? It's not really an option strategy or an income strategy as much as it is a short selling strategy.

The net result is you get a little boost to your cost basis on the stock you've sold. And since you're shorting the stock, you actually want a higher cost basis (unlike the goal of Leveraged Investing, which is to keep adjusting your cost basis lower and lower).

Let's look at how it works:

You short a stock and receive the cash equivalent of its current market price. You then write or sell an out of the money put (at a strike price below the current price) in exchange for an additional cash credit (option premium).

So, in effect, you're receiving cash upfront from two sources - the short stock sale and the short (written) put. Obviously, that raises your cost basis to a higher level than if you'd just shorted the stock alone.

So what do you gain? You essentially get a little cushion on your short stock position, so this strategy functions primarily as a either a limited hedge or as a small, stock-shorting enhancer (depending on how you prefer to view it).

And what do you lose? As I say, options are always about trade offs. The trade off here is you cap your maximum gains which would occur if the stock trades through or below the strike price on the short put. The gains on the shorted stock and the losses on the short put cancel each other out once you hit the strike price on the put.

Hope this helps -

Follow @LeveragedInvest