Covered Put Strategy
Generate income by selling put options against a short stock position. The bearish counterpart to the covered call, trading downside potential for immediate premium income.
Overview
The covered put (also called "sell-write") is the bearish mirror image of the covered call. You short 100 shares of stock and sell one put option against that position. The put premium provides immediate income, but you give up potential gains if the stock falls below the strike price.
This strategy is ideal when you have a neutral to moderately bearish outlook. If you expect the stock to stay flat or decline modestly, you keep the premium and maintain your short position. If the stock falls below the strike, you must buy back shares at the strike price—you profit, but miss further downside gains.
The covered put has the same payoff profile as a short naked call at the same strike. This equivalence (put-call parity) means both strategies have identical risk/reward characteristics. The key risk: if the stock rises significantly, your losses are theoretically unlimited.
Key Insight
Covered Put Payoff at Expiration
This diagram shows the profit/loss at expiration for different stock prices.Note: Losses are unlimited if stock rises.
Research
Research on covered put strategies and short selling with options.
The Mathematics
In Plain English
The math behind this strategy is straightforward. Here's what you're actually doing:
- 1Short 100 shares of stock at the current price (S₀)
- 2Sell 1 put option with strike price K, receiving premium C
- 3At expiration, if stock is above strike K: keep premium, maintain short
- 4At expiration, if stock is below strike K: buy shares at K, close short, keep premium
- 5Breakeven price = Original short price plus premium received
That's it. The formulas below just express this process precisely.
1Profit at Expiration
Where S_T is stock price at expiration, S_0 is initial short price, K is strike, C is premium
2Breakeven Price
Stock can rise by the premium amount before you start losing money
3Maximum Profit
Achieved when stock price <= strike at expiration
4Maximum Loss
Stock can rise infinitely, causing unlimited losses on the short position
Strategy Rules
Entry Rules
- 1Short sell 100 shares of the underlying stock
- 2Sell 1 put option per 100 shares shorted
- 3Choose strike price based on outlook (ATM, OTM, or ITM)
- 4Select expiration 30-45 days out for optimal time decay
- 5Ensure premium received is acceptable (typically 1-3% of stock price)
Exit Rules
- 1If stock < strike at expiration: assigned to buy shares, close short position
- 2If stock > strike at expiration: keep short and premium, can write new put
- 3Can buy back put early if stock rises significantly (capture most of premium)
- 4Close entire position if stock rises above stop-loss level
- 5Roll to later expiration if want to maintain position
Strike Selection
- Out-of-the-money (OTM): Lower strike, lower premium, more downside potential
- At-the-money (ATM): Strike near current price, balanced premium/downside
- In-the-money (ITM): Higher strike, higher premium, more upside protection
- Common choice: 1 strike OTM (delta ~-0.30) for balance of premium and profit
Risk Management
- Set strict stop-loss on the upside (stock rising against you)
- Monitor margin requirements—short positions require margin
- Be aware of borrow costs for hard-to-borrow stocks
- Watch for dividend dates—short sellers pay dividends
Implementation Guide
Implementing a covered put requires margin approval and the ability to short sell. This is a more advanced strategy than covered calls.
Ensure Margin Approval
Covered puts require a margin account with approval for short selling and options writing. Most brokers require Level 3 or higher options approval. You need sufficient margin for the short stock position plus any potential assignment.
- Contact your broker about margin requirements for short positions
- Understand the maintenance margin requirements
- Be aware that margin calls can force position liquidation
Short selling has unlimited risk. Ensure you understand margin requirements and have adequate capital.
Choose Your Underlying Stock
Select a stock you believe will decline or stay flat. Ideal candidates are overvalued stocks with poor fundamentals or facing headwinds. Avoid highly volatile stocks unless you want aggressive premium income.
- Check if the stock is easy to borrow (low borrow rate)
- Prefer stocks with liquid options markets (tight bid-ask spreads)
- Avoid stocks with upcoming earnings if you want predictability
- Consider dividend dates—you pay dividends when short
Short the Stock
Short sell 100 shares for each put contract you plan to write. Ensure the stock is available to borrow. Your broker will locate shares to borrow and execute the short sale.
- Check borrow availability and rate before shorting
- Use limit orders to control entry price
- Document your thesis for the short position
Select Strike Price and Expiration
Choose based on your outlook. If very bearish, sell ATM or ITM puts for maximum premium. If moderately bearish, sell OTM puts to capture more downside. Expiration of 30-45 days offers good time decay.
- Lower strike = more profit potential, less premium
- Shorter expiration = faster time decay, more active management
- Check implied volatility—higher IV means more premium
Sell the Put Option
Sell to open 1 put contract per 100 shares shorted. Use limit orders to get a fair price between the bid and ask. This is the "covered" aspect—your short stock covers the put obligation.
- Always use limit orders, not market orders
- Aim for mid-price between bid and ask
- Verify position shows as "covered" in your account
Monitor and Manage
Track your position through expiration. If the stock rises significantly, you may need to close the position to limit losses. If it falls below the strike, be prepared for assignment.
- Set alerts for price movements against your position
- Consider buying back put if it falls to 20% of original value
- Roll out (later expiration) if you want to maintain the short
- Have a clear stop-loss level for the upside risk
Unlike covered calls where max loss is limited, covered puts have unlimited upside risk. Monitor constantly.
Helpful Tools & Resources
Strategy Variations
Explore different ways to implement this strategy, each with its own trade-offs and benefits.
Reverse Wheel Strategy
Combines covered puts with cash-secured calls. If shares are assigned (you buy to cover), sell calls to potentially re-short at higher price. Continuous income generation for bearish bias.
Mirror image of the popular wheel strategy
Synthetic Short Call
The covered put is synthetically equivalent to a short naked call. Understanding this equivalence helps with position management and rolling strategies.
Put-call parity: S - P = C - K*e^(-rT)
Protective Call Collar
Add a long call above the current price while selling the put. This caps both upside losses and downside profits, often for near-zero cost.
Useful for protecting against short squeezes
Risks & Limitations
If the stock rallies significantly, your losses are theoretically unlimited. Unlike covered calls where you own stock, a short position has no natural floor. Short squeezes can cause rapid, catastrophic losses.
Short positions require margin and can be subject to margin calls. If the stock rises, you may need to add capital or be forced to close at an unfavorable price.
Hard-to-borrow stocks have high borrow rates that eat into profits. In extreme cases, your broker may force you to close the short if shares become unavailable.
When short a stock, you must pay any dividends to the lender. Unexpected special dividends can significantly impact profitability.
References
- Merton, R.C. (1973). Theory of Rational Option Pricing. Bell Journal of Economics and Management Science, 4(1), 141-183 [Link]
- Kakushadze, Z. & Serur, J.A. (2018). 151 Trading Strategies. SSRN Working Paper [Link]
- Israelov, R. & Nielsen, L.N. (2015). Covered Call Strategies: One Fact and Eight Myths. Financial Analysts Journal, 71(6), 45-57 [Link]
- Diether, K.B., Lee, K.H. & Werner, I.M. (2009). Short-Sale Strategies and Return Predictability. Review of Financial Studies, 22(2), 575-607 [Link]
Options trading involves significant risk and is not appropriate for all investors. Short selling has unlimited risk. Before trading options or short selling, ensure you understand the risks and have adequate capital. Past performance does not guarantee future results.
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