Covered puts…surprising to us…are a type of trade that very rarely get spoken about.
Well, we have no idea why…they are a fantastic idea. Maybe it’s because the are the on the sell side? I don’t know…
But whatever the case, we are here to talk about covered puts and how they can improve your bottom line…because literally, nothing else matters.
Most of us out there know about the covered call strategy. Buy 100 shares of stock and sell one call against it to “cover” the position. This allows us to collect the premium for selling the call and gives us a little more cushion on the downside. Makes sense.
But with covered puts, we can do the exact same thing. And if covered calls are such a great idea…why can’t covered puts be too?
Again, a covered call is buying 100 shares of stock and selling one call to ‘cover’ the stock. This is the simplest form of options trade there is on the block. Anyone with any type of brokerage account can do this type of trade as long as you have enough cash to buy 100 shares of stock. Our break even comes down as a result of collecting the premium in the form of a credit from the option we sold against our stock. Great.
Covered puts are the opposite of covered calls. We sell 100 shares of stock and instead of selling a call to ‘cover’ our stock, we sell a put. Makes sense. The same benefits that we get from buying we get from selling a covered put. Let’s use an example to go through this gem of a trade for people who believe a stock might go down.
Where we look to place covered call trades in stocks at the low end of their ranges, we look to place covered puts in stock at the high end of their ranges.
Here is a chart of Bank of America over the last year. We believe it is on the high end of its range as it has doubled since this time one year ago. I don’t think anyone would argue with that. If we believe selling covered puts is a good strategy for stocks at the high end of their ranges, Bank of America looks like a home run.
Right now, Bank of America is trading for $24.23. We will sell 100 shares.
In order to complete selling our covered put, we have to sell a put to ‘cover’ our short 100 shares. In this case, we are going to sell the 23 put for $0.91 in the June expiration cycle which expires 110 days from now.
This is what the complete trade looks like. Sell 100 shares of stock. Sell one put against it to cover the position.
How Much Can We Make?
Right now, Bank of America is trading for $24.23. We sold 100 shares. If Bank of America goes down, we make money. That much is obvious. But when we sell a put against 100 short shares of stock, we are agreeing to buy back those shares for the agreed-upon price (strike price) if the puts are in the money at expiration. Or in English, in doing this trade we have agreed to buy back our 100 shares of stock if Bank of America closes below $23 110 days from now.
What does this then make our potential upside? The difference between the current stock price and the strike price is $1.23 and the premium we collected in the form of a credit from the sale of the put is $0.91, so together our maximum upside is $2.14 a share or $214. That would be a roughly an 8-9% gain in 110 days.
But what about our downside? Remember we always get the premium collected from selling covered puts which can be added to our sale price to find our break even on the trade. Our break even on the trade is what we sold the shares for plus the premium collected or in this case $24.23 + $0.91 = $25.14. We do not lose money unless Bank of America is over $25.14 110 days from now.
Do You Like Covered Puts Yet?
I know you do! Becuase you liked covered calls before…and covered puts are the exact same thing to the downside. Remember, there is more to investing and trading than just simply buying and selling stocks. Collect a little extra money and give yourself a little more room to be right…how can that be a bad thing?