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Alright, in this hub we’re going to tackle the subject of covered puts. I guess it would be good before I even start rambling about the blessings of covered puts to cover what exactly a put option is. Basically, a put option is a contract that gives you the right, but not the obligation, to sell (or go short) 100 shares of stock (or in the case of commodities, one futures contract) at any time within a pre-determined period of time, at a pre-determined price (known as the “strike price”). Options in general (whether calls or puts) are very advantageous from the long side (meaning, when you’re purchasing them, not selling or writing them), because when you buy an option, you have limited risk but unlimited potential for profit. Yeah, there is an initial debit out of your trading account to purchase the option, but you can have some degree of comfort knowing that the amount you paid for the option (known as the premium) will be the absolute most you can lose (oh yeah, you need to include commissions and fees in that number as well). On the other side of the coin, when you’re writing (or selling) options, you are assuming unlimited risk but limited profit potential. When you write or sell options, the most money you can make is the premium you receive at the initial transaction. It may seem weird to anyone looking at it from the outside why you would ever want to choose unlimited risk and limited profit (selling options) over limited risk and virtually unlimited profits (buying options). The reason is simple: Probability. Just like the insurance business or the casino business, the odds are always in favor of the “house”. Option writers typically make more consistent profits from collecting premiums than option buyers make from radical price moves in a stock. But there’s always somewhat of a “cloud” hanging over the head of option sellers, because in the back of their minds there’s always that chance (no matter how remote) of getting slammed by the “big one”. In the insurance world, that would be your Hurricane Katrina. In the stock market, that would be a huge and sudden move in stock prices. I read a quote a while back that says option writers “eat like a bird but crap like an elephant”. I can definitely see where this would be true.
Writing Covered Puts
But that’s not to say that writing put options is a bad thing to do. When you write a put option, you’re basically putting yourself at the risk of having to buy 100 shares of stock (per option contract) when you don’t really want to. But hey, it may not be all that bad if you’ve done some homework on the stock and thought that it might be a good stock to own, especially if it’s currently trading at a perceived discount. That’s basically what happens when you write or sell a put option; you’re giving someone else the right to sell 100 shares of stock to you at a predetermined price (the strike price). This means that whatever the strike price of the put option is, you need to be ready to buy 100 shares of stock at that price. This is if you are not shorting the stock. If you’re shorting the stock, you are literally writing a “covered put”, because although your stock position is short, you have hedged that position somewhat by having the short put there. Writing the put will give you some up-front money (by way of the premium that you collect when writing the put) to help hedge against potential losses if the stock goes up in price and you’re left with open losses due to your position being short. So the bottom line is that if you’re shorting a stock and the price goes up, you’re screwed unless you have written a put option to help hedge against those losses. At this point, I wish I had the energy to give you some type of specific example with actual numbers and so forth, but this general example of covered puts is going to have to suffice for now. Thanks for reading, and remember to tip your waitress.