How do covered puts work

Getting Started. Planning for Retirement. Retired: What Now? Personal Finance. Credit Cards. About Us. Who Is the Motley Fool? Fool Podcasts. New Ventures. Search Search:. For the cost of the premium, protective puts provide downside protection from an asset's price declines. If an investor buys a put and the stock price rises, the cost of the premium reduces the profits on the trade.

If the stock declines in price and a put has been purchased, the premium adds to the losses on the trade. The investor does not want to sell their GE holdings, because the stock might appreciate further. The investor can purchase a put option for the stock to protect a portion of the gains for as long as the option contract is in force. The put option expires in three months. Of course, the investor would also need to consider the commission they paid for the initial order and any charges incurred when they sell their shares.

For the cost of the premium, the investor has protected some of the profit from the trade until the option's expiry while still being able to participate in further price increases. However, as with all insurance, it provides peace of mind and protection in the case of an adverse event.

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Popular Courses. Part Of. Options Trading. Futures Trading. Technical Analysis. Table of Contents Expand. What Is a Protective Put? How a Protective Put Works. Covered Puts You can profit in a declining market by selling covered puts. When you write covered puts you must do one of the following: If exercised, buy stock from the option buyer at strike price anytime before expiration. Buy the put back on the open market before exercise. Let the put expire unexercised on the third Friday.

If, before expiration, the stock begins to rise and you think it'll go higher, you can close your put and buy the stock to cover your short. Why Write Stock Options? However, as detailed in the payoff diagram later in this article, the risk of a covered put strategy is when the stock rallies above the strike price of the put. Since the investor is also short the stock, the risk is open-ended.

A covered put strategy could be used to arbitrage a put option that is perceived to be overvalued, commonly found in American-style options because of the right to exercise before expiration feature. Therefore, by simultaneously writing an in-the-money put and shorting the stock, investors can then invest the proceeds in an instrument that pays interest. Ultimately, if ever the put option is exercised, the position liquidates at breakeven and the investor keeps the interest earned, if any.

Investors using a covered put strategy is typically looking for a steady to slightly falling stock during the life of the option. A stock with a neutral outlook could also be a good candidate for this strategy.

However, this is certainly not an option strategy for stocks with a bullish outlook. An investor considering using a covered put strategy is moderately bearish in the underlying company and is writing a put option to subsidize the bearish strategy cost.

As a short seller, investors want the share price to drop. The risk stems from the share price increasing. Since a covered put strategy involves writing a put option, this provides the investor with an additional premium to use as a buffer should the share price goes up in value. If the stock price, on expiration, is higher than the strike price of the put, the option will expire worthless.

In this case, the option premium received from the put writing will help reduce the loss on the short stock position. On the other hand, if the stock price is lower than the strike price, the option will be in-the-money and will be exercised. Since the covered put strategy involves a short stock component, the investor will profit as the share price drops to a certain extent. Naturally, the option assignment will cover the short stock position.