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The covered put is a trading strategy that uses options to try and profit if a stock that has been short sold doesn't drop in price. A trader will short sell stock if they expect a drop in the share price, but there may be periods when they think the share price is likely to stay stable for a period of time i.
Because their short position won't return any profits if there is no price drop, alternative actions are required to try and make some money. This is where the covered put comes in; it involves writing put options with the expectation that they will expire worthless and provide some profit.
We should point out that this in't a commonly used strategy, and it's one that should only be considered in very precise circumstances. We have provided more information on it below. The covered put is classed as a neutral strategy, because its main purpose is to try and profit from a stock that doesn't move in price over a period of time.
It would be used if you have an open short stock position and you believe that the price of the relevant stock is about to go through a period of stability and not likely to move. You could simply close your position, but if you wanted to keep it open in the belief it will go down in the long run, then the covered put offers a way to potentially make a return during the period of stability. It will also offer you some low level protection if the price of the short sold stock went up unexpectedly.
Implementing the covered put is a very straightforward process. All you have to do is write enough puts using the sell to open order to cover the amount of stock that you have short sold.
You will need to make two specific decisions, and they are what expiration date to use and what strike to use. These decisions ultimately depend on what your expectations are and what you are trying to achieve. You should use the expiration date that is appropriate for how long you think the stock will remain stable for.
If you think it will be stable for a prolonged period of time, then you should write contracts with a long term expiration date. If you think it will be stable only for a short period, then a shorter term expiration date is appropriate. In terms of the strike, we would generally recommend that you write contracts that are at the money or just out of the money. You can use a lower strike if you wish, but you will receive less of a credit and those contracts will be cheaper. Below we have provided an example of when, and how, you might use a covered put.
This is the most you will be able to profit though, because if the price goes any lower then any additional profit you make from the original position will be offset by the put options that you have written. The biggest risk is that the price could increase by a significant amount.
If this happens, your short stock position will start to lose you money. The potential profits and losses can be summarized as follows. It has been suggested by some that profits made from a fall in the price of the stock, or losses made from a rise in the price, should't be included because those profits or losses will be made from the original position whether a covered put is used or not.
However, we have included them so that the calculations are accurate for the whole position. The calculations do not, however, take into account any profits or losses made on the original position prior to applying the covered put.
They also don't take into account commission costs. The covered put can be an effective way to profit from a short stock position when the share price is stable for a period of time. However, it does limit your potential profits should the share price fall and it only offers very limited protection should it increase. As such, this is a trading strategy that should only be considered if you are very confident that the share price will be relatively neutral for the relevant period of time.
Covered Put Strategy The covered put is a trading strategy that uses options to try and profit if a stock that has been short sold doesn't drop in price. Section Contents Quick Links. Why Use a Covered Put? Implementing the Covered Put Implementing the covered put is a very straightforward process. We shall refer to this price as the Starting Point. You believe that the price stock will remain relatively stable for a short period of time, and you want to try and profit from that stability.
Summary The covered put can be an effective way to profit from a short stock position when the share price is stable for a period of time. Read Review Visit Broker.