Knowledge Base

What is a Covered Put Strategy?

in Trading Strategies
Tags: Covered Puttrading strategy

The securities markets have a way of teasing investors. Sometimes an asset seems to be on a clear path of decline, but may rise irregularly, instead of falling linearly. This could become a source of periodic stress for you as an investor. In such cases, you can use the Covered Put strategy to benefit from a similar short term appreciation.

Let’s see how it works:

What is a Covered Put

A Covered Put strategy involves two steps. In the first, the investor borrows and sells an asset with the objective of buying it later when its price falls to make a profit. This is called short selling.

Next, he sells (or writes) an at-the-money (ATM) Put Option on the same asset. A Put Option is a contract that allows an investor to sell a specific quantity of an asset at a fixed price (strike price) on a future date (expiry), in exchange for a price called premium.

Since the investor sells the Put Option, he transfers this privilege to the Option buyer and receives the premium in return. However, on execution of the Option, he will have to buy the asset from the Option buyer. An ATM Put is a Put Option that has the same strike price as the current price of the underlying asset. It neither makes a profit nor a loss at this price.

Application of a Covered Put strategy

This strategy is used when an investor expects an asset to depreciate in the long run but appreciate a little in the short run. By short-selling the asset, the investor tries to make a gain in the long run. For the short run, he writes a Put Option with the hope that the appreciation will prevent the Option buyer from using it and he will get the premium for free.

Example of a Covered Put strategy

Let’s consider an example to understand this strategy.

Assume that a stock is currently trading at Rs 100 and is expected to depreciate to Rs 80 in six months. However, in the next two months, it could appreciate. You could benefit from these fluctuations by short selling 100 shares of the stock at Rs 100 per share and hoping to buy it back at Rs 80 per share after six months. Simultaneously, you will write an ATM Put Option on 100 shares with a strike price of Rs 100 and expiry of two months. For this, you will receive a hypothetical premium of Rs 2 per share, amounting to Rs 200 in all.

Payoff if the price appreciates

Suppose the price appreciates to Rs 102 in the following two months. The Option buyer will not use the Put Option because it will mean selling the shares at only Rs 100 per share when the market price is Rs 102 per share. You, the Option seller, will anyway receive the premium of Rs 200. Additionally, since the Option has not been exercised, you do not have to buy the shares from the Put Option buyer. This will allow you to buy them later when the price falls to your target of Rs 80 and make a bigger profit on your short sale.

Had the Option been exercised, you would’ve been compelled to buy the shares now at the strike price of Rs 100. Since you short sold the stock at the same price, your proceeds would have been limited to the premium of Rs 2 per share. Now, if the stock falls to Rs 80 in six months, you can buy it then and complete your short sale with a per share profit of Rs 20 (Rs 100 – Rs 80).

Payoff if the price depreciates

Now, suppose the stock depreciates to Rs 97 in the following two months. The Put Option buyer will exercise the Option because on doing so, he will be able to sell the stock at Rs 100 instead of the market price of Rs 97. This will lead to a gain of Rs 3 per share. After deducting your premium, his profit would be Rs 1 per share. As for the Option seller, you will have to buy the shares from the Option buyer at the original price of Rs 100, thereby not making any profit. Your only profit will be the premium inflow of Rs 2 per share. This unprofitable purchase will also complete the short sell.

Risks of Covered Put strategy

The disadvantage of the strategy is the lack of profits in case the price depreciates. You expected to complete the short sell by buying the stock at Rs 80 after six months and making a profit of Rs 20 per share (Rs 100 – Rs 80). Now, the transaction has been completed prematurely with a profit of only Rs 2 per share. So, you effectively sacrificed a massive long term profit by selling the put to prevent a small short term loss.