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Covered Put - An Option Trading Strategy

A covered put is yet another strategy used in the options market. In this strategy, the risk is not defined, and the profit is also limited. When the traders combine the short stock position with the short put options, they get the covered put options strategy. When traders want to gain some income on their short holdings and reduce the cost of the position, they enter into the covered put strategy.

Traders generally use the covered puts to earn a profit on their short holdings in their portfolio and also to reduce the cost of the position.

As options are leveraged, every contract holds 100 shares of the same underlying asset. So, to enter the covered put position, traders must require 100 shares of that stock. Traders may sell the short stock before selling the covered put or may also enter by selling the shares and selling the covered put together against the stock position.

Covered Put strategy from the market’s perspective:

When a trader has a belief that the market is bearish and needs to hold the short stock for a longer period. In this case, the covered put will help the traders profit while still having the stock. By doing so, they will also reduce the cost of the position.

How can I set a covered put option strategy?

A trader can set the covered put strategy by selling a put option against the short stock. Generally, traders sell the put options out-of-the-money below the stock's current price of an underlying asset. The put options that are sold close to the stock price receive high premiums, but their probability of expiring in-the-money also rises. When the price increases, traders do not get any advantage of entering the covered put, such as reducing the downside risk, but yes, every covered put sold adds some credit to the position, thereby lowering the cost of holding the position.

Understanding the diagram of covered put strategy?

As we discussed earlier, the downside risk is not erased by selling the covered put, but it helps reduce the cost with the premium received.

For example: Suppose a trader sold the stock at Rs. 100, and the put option is being sold at Rs. 95, with Rs 5 premium. Here, the original cost is reduced by Rs. 5, and the stock's total cost and break-even point are Rs. 105.

Now, if the stock price increases above Rs. 105, then the downside risk will be unlimited,

minus the adjusted cost. If the short put options expire in-the-money and are executed, traders will have limited profit. The profit will equal the strike price of the option plus the premium collected. The contract holder is obligated to buy the shares of the underlying asset on its strike price if assigned. Hence the short stock position should be closed.

If the stock price closes below Rs. 95 at the time of expiry, then a trader will have a profit of Rs.1000 per contract, Rs. 5 per share profit (Rs. 500) and Rs. 5 credit gain (Rs.500) from selling the covered put option. Now in another scenario. If the options expire above the short put, they will be worthless, and the only credit of Rs. 5 will remain.

Covered Put - An Option Trading Strategy

How can I enter the covered put option?

A trader must have a short stock of 100 shares to enter a covered put option. If the trader already has short stock, he may sell a put option at a lower strike price than the current price. Traders may sell the put option and the stock together.

How can I exit from the covered put?

Traders have two methods to exit from the covered put strategy at the time of expiry, based on the position of the stock price in relation to the strike price of the sold put call. If the stock price exceeds the strike price at the time of expiry, put options will expire worthlessly, and the only premium collected will be counted as profit. At this stage, the trader may enter a new position expiring on some future date. If the stock price falls below the strike price of the short put contract at the time of expiry, then the short stock is a put for the options contract holder at the strike price. Suppose the short put options expire in-the-money, but traders want to hold the position (do not want to exit). In this scenario, the position can be rolled to some later expiry date by buying the short put options contract and selling the new options contract.

Impact of time decay factor on covered put:

The time left in expiring the contract and implied volatility combined make the options contract's extrinsic value and affect the premium's price. The short put option contract having more time in expiry will be most costly as there is enough time for the asset to experience price movement. As the contract approaches the expiry, the contract loses its value.

When a trader enters the covered put options, and if they have more time in expiry, they will collect high premiums compared to those with a shorter expiration time. Thus, the time decay factor or theta favours the covered put seller.

Impact of implied volatility on a covered call:

The implied volatility shows the probability of a change in the underlying stock's price in the future. With the high rate of implied volatility, the cost of the options also rises as traders believe that price will move more in the near future. When traders sell the covered put with high implied volatility, they might receive good credit while entering. However, remember the underlying asset is expected to have fluctuations in its price.

How can I Adjust the covered put?

In case the price has moved up or down before expiry, then the trader has many methods to adjust the covered put. During the expiry, the covered put can either be. in-the-money or out-of-the-money, and traders can adjust the strategy in both cases.

In case the stock closes below the strike price of the short put option contracts at the time of expiry, then the trader must decide on something. Failing to do so, Short put options will be auto-executed, leading to the purchase of 100 shares per contract at its strike price. The stockholder will benefit when the price falls and receives the credit by selling the short put. If the price has moved beyond the lower strike price will not be counted. If the cover put contract seller does not want to execute the trade, the put option can be rolled to the next month's expiry date.

In cases where the price of the underlying asset has either moved in upward or sideways directions, and the stock price is still above the short put options, then the initially covered put will expire worthlessly. In this case, a trader can choose to enter a new position with another future date, either on the same strike price or a different strike price; whatever credit the trader has received by selling the put options will remain.

While entering the new position, if the strike price is closer to the stock price, the trader will receive good credit, but the chances of the stock expiring in the money rise and the risk of assignment stay. It is noteworthy that most assignments occur in the last week of their expiry.

How can I roll the covered put strategy?

Traders can roll the covered puts before they expire. The trader can roll the short put option contracts at a higher price on some date of the same month in case the underlying asset price has moved sideways. When a trader rolls the position and brings it closer to the current stock price, they receive high credit and have a high chance of expiring in-the-money.

If the stock price has declined beyond the strike price, traders do not wish to sell their stock and want to hold the position. In the above scenario, traders can repurchase the short put options contract and sell new contracts expiring on some future date having the same or different strike price.

How can I hedge the covered put strategy?

When the price of the stock increases, the strategy can be hedged by rolling the short put options. In order to hedge the position, traders need to buy the short put options contract at a lesser price than they were sold and sell put options at a price close to the stock price. By doing so, the potential risk on the upside will be limited, and the credit received by rolling will help traders offset any upward price movement of the underlying stock.

Another method of hedging the position is to buy the long call options having the strike price above the short put option's strike price. With the long call option, the holder has the right to purchase the stock at its strike price.

For example: if a trader has sold the short stock at Rs. 50 and the covered put at Rs.45. The trader can buy a long call option having a strike price of Rs. 55 to hedge the position. While purchasing the additional call option contract, traders may incur some extra cost, which will offset the credit received from selling the covered put options contract.

So, this was all about the covered put options strategy. If you have any doubt, you may contact us directly by calling or emailing us.

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