Definition
A Covered Put is a financial strategy where an investor sells or “writes” a put option while also shorting an equal amount of shares in the underlying asset. This strategy is used when the investor anticipates a moderate decrease in the price of the underlying asset. If the asset’s price drops, they profit; however, if the price rises, they may experience a loss.
Key Takeaways
- A Covered Put is an investment strategy used when an investor believes the price of an asset will decrease. The investor sells or “writes” put options for a stock they don’t own but plan to sell short, hence the term ‘covered.’
- The aim of the Covered Put strategy is to generate additional income from the sale of the put options, and if the stock’s price falls as expected, the investor can also profit from selling the short stock at a higher price than it is repurchased for.
- However, this strategy also involves risk. If the stock’s price increases, the investor may endure a loss on the short stock position, potentially without limit. Therefore, this strategy requires a great deal of skill, forecasting ability, and risk management.
Importance
A covered put is a financial term that holds importance as it’s an investment strategy that is used in options trading to attain potential profits when the investor expects a moderate to severe decrease in the value of the underlying asset.
By selling an asset that the investor owns and simultaneously writing a put option on it, the investor is creating a covered put.
This strategy is important because it not only offers income opportunities in the form of receiving premiums, but it can also serve as an effective method to sell assets at a decided price level.
The degree of risk is lessened compared to other forms of trading, as potential losses are offset by the premium received from selling the put option.
Therefore, understanding the concept of covered puts can aid in decision-making processes related to investment and risk management.
Explanation
The covered put is an investment strategy typically used by investors who perceive bearish tendencies in the market, or have a neutral to slightly bearish outlook for a particular asset. The ultimate goal of this strategy is for the asset to decrease enough in price so it can be profitably sold by exercising the put option. This usually occurs when the investor believes that the price of the underlying asset will decrease moderately.
By writing a put that corresponds to the underlying asset, they hope to profit from the premium income collected by writing the option, and simultaneous depreciation in the value of the asset. This trading strategy is considered riskier than other traditional strategies as it involves short selling of the underlying asset. The investor writes a put option, and then short sells the asset, agreeing to buy it back at a later date.
The payoff comes when the price of the asset falls. As the price of the asset decreases, the investor purchases the asset at the lower price to cover their short position, while keeping the premium collected from writing the put option. Should the asset’s price increase, the investor could face potential losses because they must still purchase the asset at the elevated market price to cover the short sell.
Hence, a covered put strategy should be executed judiciously, fully considering the potential risk-reward ratio.
Examples of Covered Put
Stock Market Investment: Let’s assume that an investor owns 100 shares of a tech company’s stock, which he bought for $50 per share, amounting to $
If the market conditions suggest that the stock may face a slight decline in the future, the investor could write a covered put option at a strike price of $
They may sell this option for a premium of $5 per share. By writing a covered put, they are obligated to buy 100 shares of the stock at $45 if the option buyer decides to exercise the option. This allows the investor to profit from the premium if the stock doesn’t fall below $
Real Estate Investment: Consider that a real estate investor owns a commercial property that is worth $1 million. The investor anticipates that due to certain upcoming developments in the area, the value of the property might decrease slightly. To mitigate potential losses, the investor sells a covered put option against his property with a strike price of $900k, for a premium of $50k. If the property does decrease in value, the investor is obliged to buy it back for $900k, guarding against larger loss, and also benefiting from the $50k premium.
Commodities Investment: Suppose a grain farmer fears that the price of his commodity, let’s say wheat, might fall due to an anticipated surplus in the market. The farmer then decides to write a covered put option on the wheat, with an agreed-upon price lower than the current market rate. If the price does fall, the farmer is obligated to buy the wheat at the lower rate, reducing loss. Plus, they get to keep the premium from the sale of the put option. If the price doesn’t fall as anticipated, the put option will not be exercised, the farmer can sell the commodity at the current market price, and keep the premium from the sale of the put option.
FAQs on Covered Put
1. What is a Covered Put?
A covered put is a trading strategy where an investor shorts a security he owns and then sells put options on the same security to generate income from the option premium.
2. How does a Covered Put work?
Investors use covered puts when they predict a modest decrease in the underlying security’s price. By shorting the security and selling put options, they are able to generate income from the option premium, even if the security’s price decreases significantly.
3. What is the difference between a Covered Put and a Naked Put?
A covered put strategy is when the investor shorts the underlying asset and concurrently sells an equivalent number of put options. A naked put is when an investor just sells off the put options without owning the underlying asset. The risk is generally higher in a naked put compared to a covered put.
4. What are the advantages and disadvantages of implementing a Covered Put?
A covered put has the advantage of providing steady income in the form of premiums received from selling the put options. It also protects the short position from minor price increases. However, the drawback is that the investor is exposed to significant potential losses if the price of the underlying security increases drastically.
5. How can one execute a Covered Put?
A covered put can be executed by selling short shares of an underlying security and concurrently selling an equivalent number of put options. This strategy can be executed through a brokerage account that allows for short selling and option trading.
Related Entrepreneurship Terms
- Options Contract
- Strike Price
- Expiration Date
- Underlying Asset
- Option Seller (Writer)
Sources for More Information
- Investopedia: This website provides an array of resources and articles that discuss various concepts in finance including a Covered Put.
- The Motley Fool: Brimming with investment advice, market news, and explanations about investment strategies like the Covered Put.
- Options Playbook: Detailed content on various options strategies including that of Covered Put.
- Charles Schwab: Offers a wide array of financial and investment services, with educational resources on topics such as Covered Puts.
