As you become more involved in investing and financial strategies, you're going to come across several different catch-phrases in the business that you probably haven't' heard before. As new terms arise, it's essential to learn about them, so you know precisely what they are and what they mean. It will enhance your understanding of the investor arena. One such term is Covered Put. You may be asking, what is a covered put? The simple answer is that it is a lot like a covered call, but there's a lot more to know about it. Here's everything you need to know about a covered put and its implications in investing.
What precisely is a covered put?
According to Schwab, it's a means of selling an option that takes on an underlying equity position that is short versus a long stock position. The equity position in the investor's mind is more neutral or moving towards a bearish sentiment. The purpose of a covered put creates an obligation for the stock purchase at the strike price of the option involved in a covered put. You essentially established a minimum buying price for the stock.
Options Animal goes into more detail by explaining that a covered put is not a naked cash-secured put broken down as 200 shares of the equity for each short put. It's usually sold below the current price of the underlying and the investor gets credit for the sale. If the investor holds the put option through expiration, or if it is assigned early, the investor is obligated to buy the equity at the strike price of the covered put. If the short stock position goes bullish, the short stock seller must buy the stock at a price that is more than they sold it for. The sale of the put provides a better chance of seeing a break-even pricing for the equity. They further point out that this strategy is characterized by infinite risks.
When is the best time to sell a covered put?
There are a few different times that are optimal for selling a covered put. The first is when you see the short equity position moving in the desired direction. You can wait and see what happens, or forego the gamble of the equity position reversing without notice and sell. The second scenario is to sell the covered put when a short equity position is realized.
What is the purpose of a covered put?
Similar to a covered call, a covered put is intended to reduce the risk of an investment. It's essential to note that covered puts do not eliminate all risk, but rather, they are used as a type of risk management. A covered put is a strategy for maximizing the profit, but it can work the other way. The covered put can also get in the way of realizing the full profit potential if a stock goes to the extreme in your favor since you've already set a minimum buying price on the stock. If the stock moves beyond the price you've established then you won't realize any further profit. The strategy can work against you, but it can also reduce losses by the amount of premium you received on the option's initial sale. It's not a good idea to sell the option when the position is moving in an unfavorable direction unless you believe it's going to continue to move further in the same way.
Is it required to hold a covered put to the expiration?
In most cases, you can close out a covered put before the expiration. This is done by purchasing at a price that is near the current market price, profitable, or not. The best way to maximize the return on the option is to wait until expiration, but there is nothing set in stone that requires you to wait.
What is the maximum loss potential?
The Motley Fool explains that in theory, there is no set limit to the potential loss you can experience on a covered put. Stocks can keep rising against a short position, and all a short put does is offset losses by a minor amount if the stock goes up in price. Although this is hypothetical, it's worth noting.
What is the maximum potential gain?
The maximum gain you can earn on a covered put is based on a formula that considered the option strike price, the price at which you shorted the stock and the difference between the two with any premium you received added. For example, if stocks decline to a price less than or the equivalent of a set price, you're required to purchase shares at that price. If the stock was sold short at a price that is $20 higher, your gain would be $20 plus the amount of the premium, and this is how to calculate your gain.
What if the put expires worthless?
If the put expires worthless, you will still have the premium. When figuring the breakeven on a short position, remember to figure the position cost basis plus the premium received. If you pay $21.50 and the stock declines to $20.00, then the premium will cover the loss and you achieve a break-even position.
Other aspects of a covered put to consider
The Options Guide also points out that it's important to consider the associated fees such as commissions charged. Some brokers charge a single low fee per contract and add a charge per trade. While most are relatively low, some brokers charge high commission fees along with other types of charges. Before you invest in a covered put or any other type of investment strategy, it's vital to understand all of the associated costs. Also, be aware of the potentials for gain as well as the risks of loss.
Written by Allen Lee
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