Covered Put
Risk: low
Reward: low
General Description
Buying covered puts typically entails selling out-of-the-money put options on stocks that you are short.
The Thinking
This strategy is employed when you are short and plan to stay short but you'd like to earn “residual income” from your position. You sell out-of-the-money puts and will keep the entire premium as long as the stock closes above the strike price. If the stock does close below the strike price the stock will be “put” to you and then your long and short positions will essentially cancel each other out.
Example
You are short 1000 shares of DELL @ 38 and plan on holding because you think the stock has a long ways to go on the downside. But while you are waiting, you'd like to earn a little “residual income” from your holding. You sell the (10) 32.5 puts.
As long as the stock closes above 32.5, the puts expire worthless and you keep the entire premium collected. But if the stock closes below 32.5, the stock will be “put” to you. You will then be long and short the same stock, and they will cancel each other out. You have no risk. If the stock rallies, you keep the premium and remain short (you were planning on staying short anyways). The drawback comes if the stock falls below the strike price – you will not participate in any price drop below 32.5.
The image below summarizes the trade with a P/L Diagram.
|
