In this lesson we will walk through a covered put. The principles here are very similar to a covered call but instead of a short call you will sell a short put and instead of a long spot position you are holding a short spot forex position. The benefits of lower risk, income from the premiums and smoother volatility are all the same as with the covered call.  

To gain a better understanding of this strategy, let’s look at each component of a covered put.

When you enter into a covered put you are selling a put option, which is somewhat bullish. It is bullish because a put will lose value as the market rises. If you sold the put and then it drops in value, you profit because you can buy it back later for a lower price or it may just expire worthless.

However, with a covered put, you are also short the underlying pair with a regular spot or futures position. That may sound contradictory, but in fact, it is a great position to be in. Because this trade has two contrary positions it is considered hedged. If this is all sounding very familiar to you after completing the section on covered calls then you are on the right track. A covered put is basically the opposite of a covered call.

Let’s look at an example to illustrate how this works and why it offers good profits with low volatility.

Anatomy of a Covered Put

The chart below shows a few months worth of the USD/CAD in 2008. This was an actual trade of mine and I think it is a good example of how a covered option can help minimize losses. Let’s assume that on 2/15 (the third Friday of February) you decided to enter short the USD/CAD. You then turned it into a “covered put,” when you covered the position by selling a short put. You did that because the put will pay you a premium you can use to offset any losses if the market rises against your short position in the pair. A covered put is that simple.

Here’s how that works in detail:

Step one – Sell the pair:

In the example above, let’s assume you sold the USD/CAD at 1.0067 on 2/15/2008 because you anticipated a decline in price.

Note: These is a great strategy for managing long term positions, because you may remain continuously short a particular pair for several months, and continue to sell new Put options each month against that position.

Selling the pair removes (or “covers”) the unlimited risk we previously spoke of in the short put. If the market falls, the gains in the pair offset the losses of the short put. So now we sell the Put.

Step two – Sell the Put:

Once you are short the pair, let’s assume you sell a put with a strike price that is 30-60 pips out of the money and 30 to 45 days out before expiration.

Selling the put to be a little out of the money gives your short pair position room to grow but still pays a nice premium. In the case study, you sold a Put with a strike price of 1.0000 for $100. That put is the equivalent of a 10,000 lot. When trading covered puts you want to make sure you sell an equivalent number of puts to match your spot position.

Step three – Trade conclusions

If the market falls (unlike what happened in this case)

In the example above, the market rose to 1.0234. This created a loss of 167 pips or approximately $167 per mini lot on the short pair position.

Now, the short put lost all its value because the market expired above its strike price. You originally sold the put for $100. You do not need to take any action at this point. The short put will just drop out of your account.

In this case, the trade lost much less than an outright spot position over the same time frame would have. I liked this example for this lesson because the breakout to the upside two days before expiration was so dramatic. This happens and for a long term trader, it is frustrating but the risk control from a covered put can lessen the sting considerably. But you also had upside potential if the spot trade had gone down.  

If the market falls:

Let’s assume that the USD/CAD had stayed at .9900, where it was just prior to the breakout.

Gain on spot position =      $167  (1.0067 – 0.9900)

Gain on short put =             $0 ($100 sale price - $100 expiration value)

Total gain on position =     $167

As you can see, if the pair declines, the spot position will gain in value and the put will accumulate some intrinsic value. In this hypothetical result the market closed exactly 100 pips below the strike price of the put. This means that the put expires with 100 pips or approximately $100 of intrinsic value. That will offset the premium received originally.

One Disadvantage:

Covered options can be great but they do have one disadvantage. If the market falls significantly, the short put losses cap the gains from the short spot position. What this means is that a covered put has a maximum gain potential.

That maximum gain is equal to the premium you received for the option plus the distance between the initial spot price and the strike price. In the example on the USD/CAD, the maximum gain is $167 pips. Here is a good illustration to visualize how this works.

Imagine the pair shot down, and closed at .9750 even.

Gain on spot position =      +$317 (1.0067 - 0.9750)

Loss on short put =             -$150 ($250 intrinsic value* - $100 initial premium)

Total gain on position =     +$167

The intrinsic value at expiration is calculated as the difference between the spot price and the strike price of the option.

No matter what happens beyond that point, the loss on the put you sold will always be just $167 less than the gains on the spot position.

Conclusion:

When you enter into a covered put, you are buying a hedge against losses if the market rises. You still retain upside potential, but you have given up the possibility of unlimited gains in return for that downside protection.

At first, that may sound a little strange, but because the market channels so frequently, over the long term, a covered put strategy will usually outperform an outright short position. It helps limit some of the losses you will inevitable encounter, smoothes volatility and makes your account management more efficient.

One very important note is that, like all strategies, this one can be managed as the market moves. Very frequently, as the market moves up and the put loses value, I will buy it back and resell another one closer to the current market price for another premium. That increases the amount of the hedge and amplifies long term gains. If you would like to see how that works in real time, check out our covered options strategy on the site. You can find that here. Adjusting a covered option position is the subject of the next options essentials lesson.

Watch the video below, then proceed to the next lesson: Adjusting Covered Options Positions

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Humberto  - Video tutorials   |2009-02-06 15:08:33 Hello, this is by far the best educational website I have found...I needed to refresh went back to read and watch some of the video tutorials for options and they are not there...Where did they go? regards,

John Jagerson  - Videos   |2009-02-07 04:17:39 Working on it. Our server upgrade dropped some of our videos. SHould be back shortly.

Admin  - Working now   |2009-02-09 03:34:32 They are working now. It may take a minute for the player to load, but they work now.

David  - Question about example   |2009-03-10 03:02:31 Hi, firstly I've got to say how much I love your website! Thanks for sharing all this knowledge. I have some questions about the above example, in the trade conclusion section where you lose $67 on the trade. If you had set a stoploss on the spot position of 100 pips, would you have broke even? Would this method ensure that you ALWAYS broke even? Is the potential disadvantage not giving your trade enough room to move? Apologies if this is the wrong section to ask these questions...

John Jagesron  - Question   |2009-03-10 03:06:15 David, No you would not have broken even. You would have lost your stop loss. If a trade goes bad you still suffer losses but the advantage of the option is that it allows you to let your trade run for a longer time without being whipped out.

Yes, it's avoiding the whip  - Yes, it's avoiding the whip   |2009-03-10 03:08:49 David, You are right: The major advantage is avoiding the whipsaw while still being protected to major downside moves.

David  - Thanks   |2009-03-10 08:09:50 Hi John, thanks for clearing that up, I think I understand the process a lot more now!

vladimir  - covered puts   |2009-05-25 22:57:16 Hi, John, I am again with my cash position. Assume I have 10000.00 EUR cash. And sell 1 XDE put option. Now if EUR falls against USD all the way down to the strike price of the option-minus its premium , I would finish with USD in my account at expiration ( my EUR will be exchanged into USD at the strike price ). Right ? If the opposite is the case, and EUR rises against USD, my option loses its value and I keep the premium or its part and I keep my EUR..

John Jagerson  - Covered Puts   |2009-05-26 02:19:28 XDE is a cash settled option. That means that there is no exercise. At expiration, the profit/loss amount is deposited/withdrawn in your account from your broker. That means that if you were losing in the trade, you would have those losses withdrawn at expiration rather than a settlement into another currency. The same is true in reverse for a winning trade.

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