When properly executed, covered puts can help investors manage risk by prospectively increasing profits and minimizing losses simultaneously.
What are covered puts?
There are different ways an investor can make profits from the shift in the price of stocks besides investing in the stocks themselves. Options offer plenty of strategies because of the various ways one can combine selling and buying of put and call options.
A covered put is a bearish technique that is basically a short version of a covered call. When dealing with a covered put, you are allowed to combine a short put position with a short stock position in case you are experiencing a negative outlook and considering shorting it. Another term you should know about is the ‘Poor Man’s Covered Put’, which is a put diagonal debit spread used for replicating the covered put position. According to the experts at tastytrade, “The strategy gets its name from the reduced risk and capital requirement relative to a standard covered put.”
Covered puts work almost the same way as covered calls save for the fact that the underlying equity position is a short rather than a long stock position. With covered puts, investors typically have neutral to bearish sentiments. The act of selling covered puts against a short equity position makes it mandatory to buy back the stock at a strike price.
Similar to a covered call, the perfect time to sell covered puts is either at the very time a short equity is created or as soon as the short equity position has started to shift in your favor.
When to consider using covered puts
A covered put technique can be used to arbitrate a put option that is seen to be overvalued. This strategy is commonly used in the American-styled options due to the right to execute before the expiry feature.
An investor using covered puts strategy is basically in search of a stable to relatively falling stock during the life of an option. A stock experiencing a neutral outlook can also be a good strategy for such an investor.
Why use cover puts?
Investors who use the covered puts strategy are slightly bearish in the underlying company. They then write put options in order to subsidize the bearish technique cost.
As a short seller, an investor would like to share a drop in price. The risk comes from the rise of the share price. Considering the fact that the put strategy entails writing a put option, an investor has got the advantage of extra premiums that he or she can use as a buffer in case the share price shoots unexpectedly.
How to execute a covered strategy
The successful implementation of a covered strategy depends on a number of factors. A good example is where company A is trading at $60 investors expect that the price will slightly go down. As a result, investors short 100 shares on company A at a price of $60 and write 1XA$100.
Covered puts have generally proved to be a viable strategy for investors. Although it comes with certain risks, the strategy can bear maximum results to an investor. However, it is important to take time to research and learn how the strategy works in order to maximize profits and avoid losses.
