A Covered Put (also known as a 'short stock, short put' strategy) is an options trading strategy where an investor simultaneously holds a short position in a stock and sells a put option on that same stock. It's a strategy for investors who are bearish, meaning they expect the stock's price to decline. The goal is to generate income from the premium received for selling the put option, which either enhances the profit from the short stock position or cushions some of the loss if the stock price unexpectedly rises. Unlike its more popular cousin, the covered call, the covered put is a complex strategy with a risk-reward profile that can be tricky for newcomers. While it offers a limited, defined profit, it also carries the potential for theoretically unlimited losses, a characteristic that makes most value investors tread very carefully.
Think of a covered put as a two-part bet on a stock's decline.
By combining these two actions, the short stock position “covers” the obligation you took on by selling the put. If the stock price plummets and you are forced to buy the shares at the strike price, you can simply use those shares to close out your short position. The strategy essentially puts a cap on your potential profit in exchange for the upfront premium income.
Let's walk through an example to see the mechanics in action. Imagine you're bearish on “GadgetCorp” (GC), which is currently trading at $50 per share. You decide to implement a covered put strategy.
1. **Short the Stock:** You short 100 shares of GC at $50, receiving $5,000 in your account (minus any borrowing fees). 2. **Sell the Put:** You sell one GC put option contract (which represents 100 shares) with a strike price of $45 that expires in one month. For selling this put, you receive a premium of $2 per share, totaling $200.
Your total initial cash inflow is $200. Your goal is for GC's stock price to fall, ideally to just above or at the $45 strike price by expiration.
This is your best-case scenario. The put option you sold is now in-the-money, and the buyer will exercise it. You are obligated to buy 100 shares of GC at the $45 strike price, costing you $4,500. You then use these shares to close your short position.
This is your maximum possible profit, locked in no matter how much further the stock falls.
This is the risky scenario. The put option you sold is out-of-the-money and will expire worthless. You get to keep the $200 premium, which is good. However, your short stock position is now losing money. To close your position, you must buy back 100 shares at the market price of $55, costing you $5,500.
Because a stock's price can theoretically rise indefinitely, your potential loss on the short position is unlimited. The $200 premium you collected only slightly offsets this massive risk.
The put option expires worthless, and you keep the $200 premium. Your short position has made a small profit. You buy back 100 shares at $48 to close the position.
For followers of value investing, the covered put is often viewed with skepticism. The philosophy of value investing is built on buying wonderful companies at fair prices and holding for the long term, not on short-term bets on price declines.
While not a core strategy, a sophisticated investor might use a covered put to express a strong, well-researched bearish conviction on a demonstrably overvalued company. It can be seen as a way to generate income while waiting for the market to correct what you perceive as an irrational price. It's a far more active and speculative approach than, say, simply avoiding the stock or selling a cash-secured put on a company you'd love to own at a lower price.
The primary red flag for a value investor is the unlimited loss potential. This directly contradicts the core principle of “Margin of Safety,” which is about protecting your downside. Shorting a stock, which is a required component of the covered put, can be ruinous. A stock you think is overvalued can always become more overvalued due to market mania, short squeezes, or unexpected good news. The strategy's success also relies heavily on timing the market, which is a notoriously difficult, if not impossible, game to win consistently.
It's crucial not to confuse a covered put with a naked put.
The term “covered” here can be misleading. It does not mean the position is safe; it simply means that one risk (a falling stock price) has been hedged, but it has been replaced by another, arguably bigger risk (a rising stock price). This usually requires a margin account and a high-risk tolerance.