The Covered Put is an option strategy that works similarly to to the covered call strategy, but should be used for a bearish outlook instead of a bullish outlook.

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Strategy: Covered Put

The Outlook: Mildly bearish. The stock must stay below the price at which you shorted stock, plus the premium received. But if the stock falls too much, you miss out on gains beyond the strike price.

The Trade: short stock, sell put(s), using a strike price below the current stock price.

Gains when: stock stays under the price at which stock was shorted, plus premium received.

Maximum Gain: stock short price - strike price + premium received.

Loses when: stock rises more than the premium received.

Maximum Loss : unlimited.

Breakeven Calculation: Stock short price + premium received.

Advantages compared to short stock: Some upside protection.

Disadvantages compared to short stock: cannot participate in gains beyond the strike price sold.

Volatility: after entry, decreasing implied volatility is positive.

Time: after entry, the passage of time is positive.

Margin Requirement: Depends on your broker. Some brokers will treat the short puts as naked, regardless of your being short the stock. If that is the case you would require permission for selling naked options, and a minimum margin of 10% of the strike sold plus premium received, but probably more.

Variations: use ATM strike for a neutral-to-bearish outlook.

Synthetic Equivalent: Short Call.

Comments

• Covered Puts can be used if you want to make some income during a bear market, while holding short stock for longer term bearish moves.

• You do not want to be "too" bearish in the near term, since selling the puts limits your gains to the downside.

• Covered Puts are basically the bear market equivalent of Covered Calls. See the Covered Call Strategies Disadvantages for information concerning the possible pitfalls of the Covered Call strategy, which also apply to the Covered Put.

Exits

• Since this is a mildly bearish position, the trader is expecting the stock to fall somewhat. If the stock rises instead, the premium brought in will give a slight "upside protection", but cannot make up for a large loss in the short stock. If the stock rises by more than the premium brought in, the safest course of action is to close out the entire position.

• If the stock falls, but not beyond the strike price sold, you should continue to hold the position. You will not realize the maximum gain on the premium you sold until after the option expires worthless. At that time you can buy back the stock if you wish, or continue to hold the short stock and sell more puts using the next expiration.

• If the stock falls beyond the strike you sold, it is possible you will be "put to" at any time: someone could exercise puts that they bought and thereby force you to buy the stock. Buying the stock would effectively close out the position: you are already short stock, so if you buy stock it closes out the short stock. If you do not want to risk being put to, you need to either buy the puts back, or roll them forward or down, as in the Adjustments.

Adjustments

• A common recommendation is to roll the short puts when they have lost 80% of their value due to time decay. This recommendation is actually trying to catch the point in time when the near term puts have lost most of their value, but the far term puts are not losing their value as quickly. If you wait longer so the near term puts lose all their value, then the longer term puts will probably have lost about as much.

• Another rule of thumb that usually amounts to about the same thing is to roll when there is just a week left to expiration on the near term puts. At that time, the puts expiring the next month out will have about five weeks to their expiration, and will still have decent premium for the sale.

• Rolling the puts means to buy back the near month puts you are short, and sell puts further out in time. The new puts you sell do not need to be the same strike price. If your stock has fallen, you can sell a lower strike price.

• Rolling is a type of spread trade, and most brokers give a commission discount for spread trades. A spread trade means you buy options and sell options in one transaction. You can also roll by entering two separate trades, but you will be charged two commissions.