There are several ways a trader can express their view on a stock when they trade options. An options trader can employ directional bets, as well as, non-directional bets focusing on volatility. You can even get specific, for example, some strategies let you capitalize when a stock or exchange-traded fund (ETF) trades in a range. You can also bet where you think a stock or ETF will or won’t go. In other words, you can express how bearish or bullish you are.
One strategy that is mildly bearish is called a covered put. It is a combo position, consisting of stock and options. Specifically, it’s a short stock and short put position.
Covered Put – A mildly bearish options strategy
As mentioned above, the covered put consists of stock and options.
Here’s what the strategy is all about.
Well, the strategy says that you believe that prices will not go higher, but it doesn’t necessarily mean you think that prices are going to collapse either. The way you make money on this trade is by collecting premium on the puts you sell.
For example, assume Apple (AAPL) is trading close to $175, and a trader decides to short 500 shares and short five out-of-the-money (OTM) $170 put options because they don’t believe there is much upside in Apple over the next 100 days.
The risk graph above shows that the trader will profit even if Apple trades at $181 (at expiration) because they got an extra cushion by collecting a premium in the $170 puts. That said, they stop making money after $170.
Because the short stock position offsets their short put, it’s “covered.” And hence, the name of the strategy: the covered put.
That said, the risk for this trade is undefined, and the profit potential is capped off.
Risks involved in the covered put
A covered put is the same risk profile as a naked short call.
What are the main risks involved?
Gap risk refers to a stock opening significantly higher or lower than its previous close because of a catalyst. For example, we tend to see a lot of gaps occur after a company announces earnings.
And sometimes, that can mean big money when you’re trading options.
(an overnight gap is excellent if you’re long puts and stocks crash. But your biggest fear when you have a covered put on is a gap higher.)
That said, an overnight gap higher is one of the worst things that can happen to a covered put position.
Furthermore, there are certain types of stocks you should avoid trading this strategy with:
- small-cap stocks
- stocks that have an upcoming catalyst
- stocks with high short-interest
There is plenty of edge in shorting options. However, there is some risk worth not taking.
You should avoid small-cap stocks for this strategy because many of them are volatile. For example, on March 4, Nightstar Therapeutics (NITE) gapped higher by 66% after Biogen it announced it would acquire the company.
source: Yahoo Finance
However, if you trade ETFs like the SPY or large-cap stocks like Apple, then you should be fine trading the strategy.
When Covered Puts Make Sense
This strategy works best:
- after a catalyst
- when put premiums are rich
- a stock is overbought
Now, this is a mildly bearish strategy. You put it on because you feel like the stock isn’t going to run higher much and possibly even decline. A bearish strategy would be to short the stock or be long puts. That’s why it is essential to ask yourself if your position matches your opinion.
If you are a technical trader, you want to try to find a spot where you believe the stock is having a difficult time cracking through resistance.
Now, since these are options, you also want to pay close attention to the implied volatility. As a general rule, option premiums tend to be more expensive when stocks are declining. However, that doesn’t mean they can’t get costly when stocks are rising. They can, and it typically occurs when a stock is volatile and has a catalyst.
For example, take a look at what happened to Tilray (TLRY) in 2018.
Source: Yahoo Finance
Tilray traded in a range between $20 and $300, from July to September. And you know what?
Option premiums were juiced, as FOMO traders were trying to pile into this medical cannabis stocks. Some traders who put on covered puts near the high did very well for themselves.
But you know what?
Opportunities like that are seldom. Your best bet is to find stocks that have already had a catalyst, and their move is exhausted.
Options trading allows you to be more precise with how you express your opinion. For example, a covered put is a mildly bearish strategy that looks to profit when a stock (or ETF) trades moderately higher, flat, or even declines.
Now, if you’d like to learn more about options and how to improve your results as a trader, read through 30 Days to Options Trading.
Inside you’ll discover:
- What are options?
- How do you use options?
- Basic options trading strategies
- Implied Volatility
- Factors affecting options prices
- Put-call parity
- How to choose an options broker
- How to enter your first options trade
And so much more… Make sure to reserve your free copy today.
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