Short Selling Stock Options Strategies
A covered put sell is something like a covered call in reverse. Covered put buyers,on the other hand, buy a put to profit from an owned stock in decline.
Selling Covered Puts
The seller is obligated to buy at the strike price if the buyer exercises his right to sell.
Unlike a covered call option, there is no ownership in the underlying stock, although owning the stock and selling a put on it is not unheard of.
Instead, the modus operandi is for the seller to sell short the underlying stock, enough to cover the option if the seller has to buy the stock, while at the same time selling a put.
(Shorting a stock is when an stock is sold that an investor has borrowed (usually from a broker), with the intent to buy the stock back at a later time period, at a lower price, to return to the lender.)
Income is made through generating premiums from the buyer. If it’s not exercised, and the put expires worthless, the seller makes a profit of the premium.
Put sellers often prefer options with little time left until expiration because the seller want a put to expire worthless, and the closer the option gets to expiration, the greater the probability it will expire worthless. However, an investor can still make money even if the put is exercised.
Examples of Selling Covered Puts Strategies
There are two basic option strategies to sell a covered put to an investor’s advantage:
- Sell an in-the-money covered put (stock price is less than the strike price) when one is not absolutely convinced a stock is going to drop.
- Sell an out-of-the-money covered put (stock price is greater than the strike price) when one is very bearish on the stock, for greater profit potential.
Example of an ITM Covered Put: Dow Chemical
- Say an investor shorts the stock at 25.25 per share
- Say an investor sells three contracts (300 shares) of the NOV26 Put
- Say the premium is 1.80, since three contracts were sold it equals 540 (1.80*300)
- If the stock closes below 26 at expiration, the buyer will exercise his right to sell and the seller is obligated to buy the stock at 26
- The profit is the short sales price + the premium- the strike price (25.25 * 300) + 540-(26 *300) = 315
- If the stock doesn’t go below 26, the stock won’t be sold, and the seller has to buy the stock on the open market to return the borrowed shares.
- If the investor buys it at less than the investor’s return (the short stock price + premium) of 27.05, a profit will be made.
Example of OTM Covered Put: Boeing
Boeing has recently been downgraded by several analysts and its 3rd quarter earnings slipped as well.
- Say you short Boeing at 48.81 per share
- Say an investor sells three contracts (300 shares) of the NOV50 Put
- The premium is 2.50, since three contracts were sold, it equals 750
- If the stock closes below 50 at expiration, the buyer will exercise his right to sell and the seller is obligated to buy the stock at 50
- The seller’s profit is the short sales price + the premium- the strike price (48.81 * 300) + 750-(50*300) = $393
- If the stock doesn’t go below 50, the stock won’t be sold, and the seller has to buy the stock on the open market to return the borrowed shares.
- If the investor buys it at less than the investor’s return (the short stock price + premium) of 51.31, a profit will be made.
Buying Covered Puts
The buyer is protecting a position on stock owned, is expecting the stock to decrease in price over the next couple of months and wants to profit on that decline.
Example of Buying a Covered Put: Nucor Corp
Say one own Nucor Corp, which is currently trading at $41.25 per share
- If an investor expects the price to decrease significantly over the next couple of months, purchase a put option to profit from the expected movement.
- Say an investor buys a DEC 45 put for 2.30
- Say the buyer speculates correctly, and the stock falls to 37 during the period owned.
- The price of the option will more than triple during that time period because the option will be priced at least $8. (The 45 you can sell it at minus the current price of 37 you can buy it at).
