How to Write
Covered Puts

Covered Puts

You can profit in a declining market by selling covered puts.   Put options give the option buyer rights to sell stock (to the option seller).  Puts are used when you think the stock's price will decline.  Puts are covered puts when the option seller is short stock that the covered puts are written against.

Covered Puts Strategy

When advisors suggest writing puts they generally mean naked puts, which are very risky.  With covered puts you have already sold the stock short, so you don't care if it drops sharply.   By writing covered puts, you're making monthly income selling downside protection to investors.  Writing covered puts gives someone rights to sell you stock that you (if exercised) buy at the option strike price.

Contrary to popular belief, it's good to have the puts you sold exercised.  If you sell low risk ITM covered puts, your profit ((short sales price+premium) - strike price) is locked in when you sell the covered puts.

When you write covered puts you must do one of the following:

• If exercised, buy stock from the option buyer at strike price anytime before expiration.
• Buy the put back on the open market before exercise.
• Let the put expire unexercised (on the third Friday).

In-the-Money Covered Puts

If you're not totally convinced of a drop in stock price, sell ITM covered puts.  The advantage of an ITM put is better downside protection.  You profit regardless of the direction of the stock.

For instance, if you sell short 100 shares of stock for $9.25 per share, you could write a $10 ITM covered put and get a premium of, say, $1.50.

If the stock does close below $10 at option expiration, you must buy the stock for $10.  You profit because you already sold it for $10.75 ($9.25 short sale, plus $1.50 premium) and you can use the stock to cover your short (return borrowed stock).

Otherwise, if the stock doesn't close below $10 at option expiration, the stock won't be sold to you.  You must then buy stock on the open market to cover your short.  As long as it's below $10.75, you profit.

Out-of-the-Money Covered Puts

If you are very bearish on a stock, sell OTM covered puts.  Then you have extra profit potential.  If you sell short 100 shares of stock for $5.25 per share, you could write a $5 OTM covered put and get a premium of, say, $0.50.

If the stock closes below $5 at option expiration, you must buy the stock for $5 producing $0.25 capital gain ($5.25 short sale, minus $5) in addition to the $0.50 premium already received; and you can use the stock to cover your short (return to the lender).

Otherwise, if the stock doesn't close below $5 at option expiration, the stock won't be sold to you.  You must then buy stock on the open market to cover your short.  As long as it's below $5.75, you profit.

• If, before expiration, the stock begins to rise and you think it'll go higher, you can close your put and buy the stock to cover your short.