Covered Put Explained

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Covered Put

Writing covered puts is a bearish options trading strategy involving the writing of put options while shorting the obligated shares of the underlying stock.

Covered Put Construction
Short 100 Shares
Sell 1 ATM Put

Limited profits with no downside risk

Profit for the covered put option strategy is limited and maximum gain is equal to the premiums received for the options sold.

The formula for calculating maximum profit is given below:

  • Max Profit = Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying

Unlimited upside risk

As the writer is short on the stock, he is subjected to much risk if the price of the underlying stock rises dramatically. In theory, maximum loss for the covered put options strategy is unlimited since there is no limit to how high the stock price can be at expiration. If applicable, the covered put writer will also have to payout any dividends.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying >= Sale Price of Underlying + Premium Received
  • Loss = Price of Underlying – Sale Price of Underlying – Premium Received + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the covered put position can be calculated using the following formula.

  • Breakeven Point = Sale Price of Underlying + Premium Received

Example

Suppose XYZ stock is trading at $45 in June. An options trader writes a covered put by selling a JUL 45 put for $200 while shorting 100 shares of XYZ stock. The net credit taken to enter the position is $200, which is also his maximum possible profit.

On expiration in July, XYZ stock is still trading at $45. The JUL 45 put expires worthless while the trader covers his short position with no loss. In the end, he gets to keep the entire credit taken as profit.

If instead XYZ stock drops to $40 on expiration, the short put will expire in the money and is worth $500 but this loss is offset by the $500 gain in the short stock position. Thus, the profit is still the initial credit of $200 taken on entering the trade.

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However, should the stock rally to $55 on expiration, a significant loss results. At this price, the short stock position taken when XYZ stock was trading at $45 suffers a $1000 loss. Subtracting the initial credit of $200 taken, the resulting loss is $800.

Note: While we have covered the use of this strategy with reference to stock options, the covered put is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Naked Call Writing

An alternative but similar strategy to writing covered puts is to write naked calls. Naked call writing has the same profit potential as the covered put write but is executed using call options instead.

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Covered Options Explained – Covered Calls and Puts

Covered Calls/Puts are one of the most common and good option strategies, especially among beginner option traders. It is one of the best ways of getting into options when you come from stock trading. It combines stock and option trading. This is neither an option only or a stock only strategy. This strategy is also a good introduction and first step into high probability option trading. The idea behind covered calls/puts is to cut the upside potential for an increase in likelihood of success. With this strategy, you can slowly finance the bought shares with the money from the sold options. I will try to break down the covered call/put strategy in the following article.

Covered Calls Explained

Market Assumption:

When writing covered calls on your existing stock positions, you still can have more or less the same market assumption as before. Without a covered call you hope that the stock price will go up as much as possible. But with a covered call, you actually don’t really care if the price goes up or just stays the same. As long as the price does not go down, you can make money. So your ideal market assumption should be slightly bullish to neutral. If you are very bullish and expect the underlying to skyrocket within the next few days, a covered call is probably a bad idea, because this would cut all your gains after a certain price point.

Setup:

  • Sell 1 Call (for every 100 shares of stock)

The sold option should result in a credit (get paid to open).

Profit and Loss:

When you look at the payoff diagram of the selling covered calls strategy, you can see that it looks somewhat similar to the payoff diagram of a stock and a credit spread. The downside is exactly the same as the one of a normal stock and the upside is just like one of a credit spread. So if the price of the underlying moves down, you lose money linear. Your max profit will occur when the underlying’s price moves up and beyond the strike of the sold option. The loss is unlimited, so this strategy is a defined profit and undefined risk strategy. This may seem like a downgrade from a normal stock without a covered call, but this is not the case. For every sold option, you take in some money. This means that your break even point and your entire stock payoff will move a little to the left. This gives the stock’s price more room to move in. If the stock price, would not move at all for a few years and you constantly sell covered calls on it, you will still make money. This would not be the case, if you hadn’t written covered calls. Basically you can slowly finance your stock position with covered calls.

Maximum Profit: Premium received + Strike Price – Trading Price of Underlying when bought – Commissions

Ex. (ABC was trading at 100 at time of long entry, Call sold at 105 Strike) => 20$ (Premium) + 105 (Strike) – 100 (Underlying Trading Price at Entry) – 3$ (Commissions) = 22$ (*100, because you have to own and the option normally controls 100 shares) = 2200$ (max profit)

Maximum Loss: N/A (unlimited)

Implied Volatility and Time Decay:

Time Decay or the option Greek Theta works in favor of a covered call. This means, the more time goes by, the more profitable this strategy will be. This is the case due to the loss of extrinsic in the sold options. The amount of lost value increases, the closer you get to expiration.

A covered call profits from a drop in implied volatility (IV) and should therefore ideally be used in times of high implied volatility (IV rank over 50). Doing this will increase the premium taken in and can eventually increase your chances of winning. Nevertheless, it is not necessary to trade covered calls in a high IV environment.

Covered Calls Video Lesson

Check out the following video lesson to learn everything you need to know to trade covered calls successfully:

Covered Puts Explained

Covered Puts are more or less the same as covered calls, just for shorted stock and with a put. So this strategy only works if you have a short position in some kind of underlying.

Market Assumption:

Before writing a covered put you probably already shorted some kind of asset, so your directional assumption on that asset clearly should have been bearish (you hope the price falls). This should stay more or less the same. The only difference being that you don’t hope for a huge down move with a covered put. With a covered put you should be slightly bearish to neutral. Just like it is with covered calls: if you are very directional, covered puts/(calls) are not for you.

Setup:

  • Sell 1 Put (for every 100 shares of stock)

The sold option should result in a credit (get paid to open).

Profit and Loss:

The covered puts strategy is a defined profit and undefined risk profit strategy. The payoff to the upside stays the same as it would have been for a normal short stock. But profit potential to the downside will get cut off. So if the price of the underlying moves to a certain point, you won’t make any more money. This may seem like a downgrade from a normal stock without a covered put, but this is not the case. For every sold option, you take in some money. This means that your break even point and your entire stock payoff will move a little to the right. This gives the stock’s price more room to move in. If the stock price, would not move at all for a few years and you constantly sell covered puts on it, you will still make money. This would not be the case, if you hadn’t written covered puts. So with covered puts, you can slowly finance your stock position. Max profit will be achieved if the underlying’s price moves down to or further than the strike of the sold option.

Maximum Profit: Trading Price of Underlying when sold/shorted – Strike Price + Premium received – Commissions

Ex. (ABC was trading at 100 at time of short entry, Put sold at 95 Strike) => 100 (Underlying Trading Price at Entry) – 95 (Strike) + 20$ (Premium) – 3$ (Commissions) = 22$ (*100, because you have to own and the option normally controls 100 shares) = 2200$ (max profit)

Maximum Loss: N/A (unlimited)

Implied Volatility and Time Decay:

Just as a covered call, a covered put also profits from time decay. The more time goes by, the more the sold options will lose in value, thus creating a profit for a covered put writer.

The covered put strategy also profits from a drop in implied volatility (IV) and should therefore also ideally be traded in a high IV environment (IV rank over 50). But again, this is not necessary.

Trader’s Note:

Covered Calls and Puts are great strategies that have the potential to generate well-sized profits. I think this strategy is a great and common way to transition from stock to option trading. But as clearly seen, this strategy does still require the belonging of stock (and quite a lot of it as well). Options normally control 100 shares of stock, so just to write one covered put/call, you have to be long /short 100 shares of an underlying. This can be very capital extensive, especially for beginners. But in my opinion one should never buy any shares, just to do covered calls/puts on them. This would be a very stupid move. Covered puts/calls should only be done if you already (plan on) have shares in a certain stock. It is just a good way of capping the profit potential for some high probability premium.

Additionally, I think trading covered calls/puts is not only a good introduction to option trading, but especially to (high probability) option selling, which is great. The idea behind high probability option selling is to remove some upside potential to increase the chances of winning.

If you want to learn a similar strategy that does not require you to own any shares, you could check out my strategy breakdown of credit spreads here. Credit spreads work almost the same, just without the stock.

Nevertheless, I really believe that covered calls/puts are a very great strategy. Prices do very rarely move big amounts at a time and it is even harder to predict the very few stocks that actually do that. This is what covered options and high probability option selling in general takes advantage of. To learn more about options and my profitable high probability option selling strategy, check out my education section here!

4 Replies to “Covered Options Explained – Covered Calls and Puts”

I liked reading about the covered calls as a strategy for income. I have actually doe this and recommend it for investors who have larger accounts and are holding stock in their portfolios. It is a good introduction to high probability option trading as the object is for the options to expire worthless after seolloing them. The examples were a olittoe hard to follow if someone is not ready famiolar with trading in general and options in particular. Over all a good explanation of what a covered call trade is. I was looking around your site further and really like the way you have the menu arranged with multiple dropdown I willo have to see if I cn impolient that in mine, I really like using the weeklies for this as well as the other income trades as they are faster to compete and give more opportunities for profit and quicker recovery of the cost of the original stock – nice to get it down to zero cost to own a good stock.
I will be going back over the rest of your site as time allows. Nicely done thanks.
Louis

Thanks so much for the positive feedback. It seems like you really have understood covered calls!

What is a Covered Call? Learn the Pros and Cons

Before diving into the complexities of what a covered call trade is and how it can be used to generate portfolio income lets first define what an option contract is and what it means to each party involved. There are two main types of options, call options and put options. A call option is a contract that gives the holder (buyer) the right, but not the obligation, to buy a security at a specified price for a certain period of time.

Buying one call stock option gives the purchaser the right to buy 100 shares of a stock. If the stock price is greater than the options exercise (strike) price the option can be exercised and the option buyer will make a profit based on the difference between the current price and the strike price. When this happens the option is considered to be ‘in the money’. If the price of the stock is below the strike price on expiration the option becomes worthless or ‘out of the money’.

It is possible for an investor to either buy or sell options; selling naked calls means an investor sold a call option without owning any underlying stock to offset option. Selling naked calls is a very risky endeavor. If an investor sells a naked call and the stock dramatically rises above the options strike price the investor will owe 100 times the difference between the stock price and the options strike price.

Both buying call options and selling naked call options are speculative strategies where the investor stands to only make a profit if they correctly guessed the direction of the stock’s price.

Between the date the option contract is initiated and the date it expires the price of the stock will constantly fluctuate. The more a stocks price is expected to fluctuate over this time frame the harder it is to predict whether or not the option will be in the money at expiration. To account for this, options are priced at a premium, and that premium declines as the expiration date nears. All else held the same, an option expiring in one month will be worth more today than tomorrow if the stock price remains the same. For more detailed information on how options are priced read The Greeks: From Past to Present.

Covered Calls Explained

What is a covered call? Let’s now look at an example. XYZ stock is trading at $52 today; a call option to purchase XYZ at $55 one month from now is priced at $3. To initiate a covered call on XYZ stock an investor would purchase 100 shares of XYZ and sell a call option which obligates him to sell XYZ at $55 one month from now if exercised by the option buyer. For simplicity we will ignore commissions.

Pros of Selling Covered Calls for Income

– The seller receives the premium from writing the covered call immediately on the date of the transaction, in this case $300. If the price remains below $55 at option expiration the seller will keep the 100 shares of stock and the $300 he received for the option.

– If the price of the stock is over $55 at option expiration the call option will be exercised. At this point the 100 shares of stock are sold, the investors profit is equal to the $300 received for selling the option plus the $300 in capital appreciation (100 shares * ($55 sell price – $52 purchase price)) for a total profit of $600.

– The premium received can help offset a downward move in the stock price. In this example the investor purchased the shares at $52, if the stock were trading at $49 on expiration and the investor decided to sell his shares the total profit would be $0. The $3 loss on the shares of stock is offset by the $3 received in option premium.

Cons of Selling Covered Calls for Income

– If the stock rises well above the strike price, the seller does not enjoy the full appreciation. The seller’s profit is limited to the premium received plus the difference between the stocks purchase price and the options strike price.

The option seller cannot sell the underlying stock without first buying back the call option. A significant drop in the price of the stock (greater than the premium) will result in a loss on the entire transaction.

– Premium amounts are based on the historical volatility of the underlying stock. Stocks with higher option premiums will have a greater risk of price fluctuation.

– Losses due to downward moves in the underlying stocks price are only limited by the amount of premium received.

Is Selling Covered Calls “Worth It”?

As you can see, selling covered calls for income offers both advantages and disadvantages to outright stock ownership. They can be a great tool to generate additional income from an equity portfolio; however using only a simple covered call strategy can get you into trouble due to its limited upside potential and limited downside protection.

Strategies using options to generate income can be as simple as selling covered calls, while others add strict rules and processes to manage income, emotion and risk. If you are looking to add an income producing strategy using options, compare the risk/reward profiles of every strategy and pick one that matches your objectives, risk tolerance, time horizon and temperament. For more information on using options in your portfolio read our free special report: Myths & Misconceptions About Exchange Traded Options.

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