Unlike long stock, investors with a short stock position benefit when the share price falls. As a result, selling an out-of-the-money (OTM) put against any round lot of short shares will cap profits since it limits downside exposure. For example, an investor holding 200 short shares of XYZ @ $50 can sell 2 $45-strike puts against it. It's worth noting that establishing or maintaining a short stock position is only allowed in a margin account, so establishing a covered put in any other kind of account is not permitted.
Since each long put gives the buyer a right to sell 100 shares of stock at the option's strike price, a put option seller must buy the stock at the option's strike price if the long holder exercises early or if it expires in-the-money (ITM) by $0.01 or more at expiration. In short, options buyers buy a right to sell shares at the option’s strike price, and sellers are obligated to buy 100 shares per contract at the option's strike when the long holder exercises or if it expires ITM.
Assuming the put option sold against the short stock position remains OTM during the life of the trade, the value of the put option sold may erode each day due to time decay. As a result of remaining OTM and time decay, it potentially can be covered (purchased back) below the selling price to yield a profit. A put option that expires OTM at expiration will be worthless and yield a max profit. The profit from the covered put positions may help generate income for investors with short stock positions. Additionally, investors short any dividend-paying stocks may offset any dividends owed or carrying costs with any profits made by selling covered puts too. Carrying costs refer to hard-to-borrow fees charged to investors that establish short stock positions in a heavily shorted stock.
A covered put gets its name since each short put covers 100 short shares if assigned early or expiring ITM. Assuming an account with only a covered put position in their portfolio, the account would be flat (no shares) and prevent it from being long 100 shares if the option faces early assignment or if it expires ITM.
Although selling a put against 100 short shares to form a covered put position can potentially generate interim income or potentially offset any dividends or carrying costs owed from a short stock position, this strategy has unlimited risk as you are holding a short stock position. If the stock price rises, it could yield a profit on the short put position, but the gain may not cover the losses sustained from the stock price rise since it can, in theory, rise infinitely. Additionally, puts sold above the short stock’s sale basis could result in locked-in losses if the account experiences an early assignment or by expiring ITM, which would cover or close the short shares.
For example, if you originally opened 100 short shares of XYZ @ $50, but it is currently trading at $70, then selling a $60-strike put for a $1 credit against the short shares could lock in a $1,000 loss on the short shares, or a $900 total loss when considering the credit received on the 60-strike short put, if the short share were covered early by assignment of or if XYZ closed ITM below $60 at expiration.
Profit & Loss Diagram of a Covered Put
The profit and loss diagram below assumes the covered put sold below the short stock's basis. Since investors selling covered puts are selling their downside, an investor's max profit will cap when the underlying drops below the covered put's strike price, as illustrated where the green profit zone flattens. Theoretically, a short stock position has unlimited losses since it can continually rise in perpetuity. The potential profit on the short put may not cover the losses on the appreciated shares.
