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. They can even get specific: For example, some strategies let traders capitalize when a stock or exchange-traded fund (ETF) trades in a range. Traders can also bet where they think a stock or ETF will or won’t go. In other words, traders can express how bearish or bullish they are.
One mildly bearish strategy is called a covered put. A covered put option is a combo position, consisting of stock and options. Specifically, it’s a short stock and short put position. If you’re trying to learn the basics of trading, you should spend some time getting familiar with covered put options. Here’s a quick in-depth look into how covered puts can boost your profits if you use them correctly:
Covered Put — A Mildly Bearish Options Strategy
As mentioned above, the covered put consists of stock and options.
Here’s how covered puts can help you maximize your profits if used intelligently:
When you use a covered put strategy, you’re essentially taking the view 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 premiums on the covered 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 covered 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 has the same risk profile as a naked short call.
What are the main risks involved in using covered put options? Gap risk.
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. Take a look at this example:
An overnight gap is excellent if you’re long on puts and stocks crash. But your biggest fear when you have a covered put on is a higher gap. 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 the covered put 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 are some risks not worth taking.
You should avoid using the covered put strategy on small-cap stocks because many of them are volatile. For example, on March 4, Nightstar Therapeutics (NITE) gapped higher by 66% after Biogen 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 implementing the covered put option strategy.
When Covered Puts Make Sense
The covered put strategy works best:
- After a catalyst.
- When put premiums are rich.
- A stock is overbought.
Remember that the covered put strategy is considered mildly bearish. You will generally use covered put options because you feel like the stock isn’t going to run much higher and it will possibly even decline. A bearish strategy would be to short the stock or be long on puts. That’s why it is essential to ask yourself if your position matches your opinion.
If you are a technical trader, you’ll 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. 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 movement is exhausted before you consider using a covered put option strategy with them.
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.
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- 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.
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