A covered put sale is a strategy that involves selling a put option on a stock that you already own or plan to buy. A put option gives the buyer the right to sell the stock at a specified price (called the strike price) before a certain date (called the expiration date). By selling a put option, you receive a premium from the buyer, which is your maximum profit from this trade.
The reason why you sell a put option is because you are bearish on the stock, meaning you expect its price to go down. You want to protect yourself from losing money if the stock drops below the strike price of the put option. However, by selling a put option, you also limit your upside potential if the stock rises above the strike price of the put option.
For example, suppose you own 100 shares of XYZ stock, which is currently trading at $50 per share. You decide to sell one put option contract on XYZ with a strike price of $45 and an expiration date of one month from now. You receive $2 per share as premium for selling this put option.
If XYZ stays above $45 until expiration, both you and the buyer of the put option will lose money. The buyer will not exercise their right to sell XYZ at $45, because it is higher than the market price. You will keep your 100 shares of XYZ and your $2 per share premium as profit.
If XYZ falls below $45 before expiration, both you and the buyer of the put option will make money. The buyer will exercise their right to sell XYZ at $45, because it is lower than their purchase price. You will have to buy back 100 shares of XYZ at $45 per share from them and deliver them to them. You will then close your short position on XYZ by buying back 100 shares at market price and holding them for future appreciation or depreciation.
The net result is that you will make more money than if you did not sell any put options on XYZ. However, this also means that you have given up some potential upside if XYZ rises above $45 before expiration.
A covered put sale is a simple and effective way to generate income from your existing stock holdings while reducing your downside risk. However, it also has some drawbacks and risks that you should be aware of before using this strategy.
Some of these drawbacks and risks are:
- You may miss out on some gains if XYZ rises significantly above $45 before expiration.
- You may incur additional costs such as commissions and fees for selling and buying options.
- You may face margin calls or liquidation if your short position on XYZ becomes too large relative to your available funds.
- You may face assignment risk if another trader buys your short position on XYZ at a higher price than market price.
- You may face time decay risk if your short position on XYZ loses value due to decreasing volatility or increasing time until expiration.
Therefore, before using a covered put sale strategy, you should consider your risk tolerance, market outlook, portfolio objectives, and alternative strategies that may suit your needs better.
Basic Theory:
A covered put sale consists of two main components:
- Short Stock Position: The investor holds a short position in the underlying stock, expecting its price to remain stable or decline slightly.
- Short Put Option Position: Simultaneously, the investor sells a put option, giving the buyer the right to sell the stock at a specified price (strike price) within a specified period.
The goal is to profit from the premium received by selling the put option, and if the stock price remains above the strike price at expiration, the option expires worthless.
Procedures in Excel:
To implement a covered put sale in Excel, you can follow these steps:
- Create an Excel Table: Set up a table with columns for Stock Price, Put Option Premium, Strike Price, and Profit/Loss.
- Input Parameters: Define the initial stock price, strike price, and the premium received for selling the put option.
- Calculate Stock Position P&L: Use Excel formulas to calculate the profit or loss on the short stock position based on changes in the stock price.
- Calculate Put Option Position P&L: Use Excel formulas to calculate the profit or loss on the short put option position, considering the premium received and changes in the stock price.
- Aggregate Profit/Loss: Combine the P&L from the stock position and the put option position to determine the overall profit or loss.
Real-Life Scenario:
Let’s consider a scenario with the following parameters:
- Initial Stock Price: $100
- Strike Price: $95
- Put Option Premium: $3
| Stock Price | Put Option Premium | Strike Price | Stock P&L | Put Option P&L | Total P&L |
|---|---|---|---|---|---|
| $100 | $3 | $95 | =B2-A2 | =C2-(B2-A2) | =D2+E2 |
Calculation:
- Stock P&L: $100 (current stock price) – $95 (initial stock price) = $5
- Put Option P&L: $3 (premium received) – ($100 – $95) = $3
- Total P&L: $5 (stock P&L) + $3 (put option P&L) = $8
Result:
In this scenario, the covered put sale strategy results in a total profit of $8.
Other Approaches:
- Adjusting Strike Price: You can explore the impact of using different strike prices to optimize the strategy.
- Dynamic Scenarios: Use Excel’s data tables or scenarios feature to analyze various market conditions and their effects on the covered put sale strategy.
