What is a Covered Put Strategy?

A Covered Call Approach is the polar opposite of this strategy. A Covered Call strategy is neutral to bullish, whereas a Covered Put approach is neutral to bearish. When you're an investor, you use this technique when you think the price of a stock or index will stay in a narrow range or fall. Covered Put writing entails selling a stock/index short and selling a short Put on the stock/options. Indexes.

Covered Put Strategy Explained

The Put that is sold is usually an out-of-the-money put. Shorting a stock indicates that the investor is negative on it, but he is willing to purchase it back once the price reaches (falling to) a target price. This is the price at which the investor sells the Put short (Put strike price). If a put is sold, it means that if it is exercised, the stock will be purchased at the strike price. If the stock falls below the Put strike, the investor will be exercised and will have to purchase the stock at the strike price. It is his target price, to repurchase the stock at the strike price - which is his target price to repurchase the stock at the strike price.

Because the investor has shorted the stock, acquiring it at the strike price simply closes out the short stock position at a profit. The Premium on the Put sold is kept by the investor. Because he shorted the stock in the first place, the investor is protected. The investor keeps the Premium if the stock price does not change. In a neutral market, he can employ this method to generate income.

When to Use the Covered Put Strategy?

The right time to use the covered put strategy is when the trader is neutral or is slightly bearish in the market. He would be expecting the price of the underlying to go down slightly and wants to make a profit on it. The strategy is wholly unsuitable when the price of the security is expected to go up, and in this case, it will lead to unlimited loss.

This strategy makes sure that the profits are earned if the stock price goes down. It will also move the breakeven point higher and give a wider margin of error. It means that before the trader does start incurring losses, the stock price needs to move higher than the amount of Premium that has been received.

The Premium that is received by writing the put option needs to compensate for a part of the loss or would increase the profit by the same amount. This strategy has a limited profit margin. In the absence of a covered put, the trader could keep on earning profits as the price of the underlying keeps going down.

Because of the presence of the Put in the covered put strategy. If the price of the stock goes less than the strike price of the put option, then the put option will expire and will have to be brought back. The gains from shorting the stock would be balanced out through the loss in buying back the Put, and the profit becomes capped.

Importance of a Covered Put

An investor considering a covered put strategy is relatively bearish on the underlying company and is writing a put option to help defray the cost of the bearish approach.

Investors that trade short expect the stock price to fall. The danger derives from a rise in the stock price. Because a covered put strategy entails writing a put option, the investor receives an additional premium to utilize as a cushion if the stock price rises. The option will expire worthless if the stock price on expiration is higher than the strike price of the Put.

In this situation, the put writing option premium will assist in reducing the loss on the short stock position. If the stock price is lower than the strike price, on the other hand, the option will be in the money and exercised. Because the covered put method includes a short stock component, the investor will profit if the stock price lowers.

Benefits of the Covered Put Strategy

• As the Put is so far in the money, the maximum profit is restricted to any interest earned on the initial cash plus any time value in the option when it is sold. 
• The best-case scenario is that the stock price stays significantly below the strike price, implying that the option would be exercised before it expires and the position will be liquidated.
• The stock profit or loss is equal to the sale price minus the acquisition price, in other words, where the stock was sold short minus the option strike price. 
• Add in the Premium you got for selling the option, as well as any interest you got. Keep in mind that the strike price minus the current stock price is the intrinsic value of a put. 
• So - if the option was sold for the intrinsic value in relation to the stock being sold short, exercising the option results in a profit or loss of zero, excluding any interest earned.

Drawbacks of the Covered Put Strategy

• Assignment risk exists when an investor writes an option. Early exercise simply means that no more interest is received from the method because the assignment liquidates the investor's stake. Also, be aware that if a stock is involved in a restructuring or capitalization event - such as a merger, or special dividend, usual expectations for early execution of options on the stock may be entirely thrown off.
• Expiration risk exists in a covered put strategy. However, there's a chance that late news prevents the option from being exercised, resulting in a big increase in the stock the following Monday. A big rise in the stock price, not only near expiration, is always a threat to this strategy.
• Since the investor is shorting the company, they are responsible for any dividends due during that time.