What Is a Covered Put?

By Markets Fool.com

There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.

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A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.

A fairly basic position is the covered put, which is very similar strategically to a covered call.

The basic setup

A covered put is a bearish strategy that is essentially a short version of the covered call. In a covered put, if you have a negative outlook on the stock and are interested in shorting it, you can combine a short stock position with a short put position. This creates some immediate income upfront from the premium received from writing the put. It also limits your potential gain on the short position, since if the stock decreases to below the put's strike price, you will subsequently purchase the shares through the option exercise and close out your short position.

For example, let's say that you short sell a stock at $50, but don't necessarily think it will decline to lower than $45. You could sell a $45 put as a way to generate income while limiting your gains if the stock declines in your favor. Let's assume that the premium for the put is $1.50.

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Maximum loss: unlimited

There is no theoretical limit to how much you can potentially lose on a covered put. This is due to the fact that stocks do not have a maximum limit, and a stock can continue rising against a short position. This unlimited maximum loss is also true for any short stock position; a short put would only merely offset losses by a small amount in the short stock position should the stock increase in price. Of course, in reality stock prices don't increase to infinity, so this risk is purely hypothetical.

In this example, if the stock were to jump to $90, the stock position would lose $40, but netting out the $1.50 in premium received would yield total losses of $38.50.

Maximum gain: difference between put strike price and short stock price plus premium received

The most that you can make on a covered put position is the difference between the option strike price and the price that you shorted the stock, plus any premium received. This occurs if the stock declines to a price less than or equal to the put strike price, in which case the option is exercised and you purchase the stock at the strike price and cover your short position.

In this example, if the stock were to decline to any price less than or equal to $45, you would be required to purchase shares at $45. Since you sold short the stock at $50, you would have a gain of $5. You would then add in the $1.50 in premium for a total gain of $6.50.

Breakeven: short position cost basis plus premium received

The breakeven point for a covered put is the cost basis of the short position plus the premium received. If the stock price begins to increase, the short stock position begins to lose value, but the premium received will offset these losses to a point. If the stock increases above this point, then you begin to accrue losses.

In this example, the breakeven point is $51.50. If the stock price increases to $51.50, then the short stock position has current losses of $1.50, which is exactly offset by the $1.50 in premium received initially.

Generating income

Much like a covered call position, which is a popular income-generating position among options investors, a covered put can also generate income. If the put expires worthless and you keep the premium received as realized gains, you can choose to sell another put and repeat the process provided that you are still comfortable holding the short stock position.

The article What Is a Covered Put? originally appeared on Fool.com.

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