Covered Puts (Protected Short Sale)


In this strategy, an investor is in a short stock position combined with a short Put position. The investor is neutral to bearish on the underlying.  Generally the investor will sell stock short, then sell a Put with a lower strike price than the underlying stock.  The short Put premium provides  limited protection should the stock move higher.  Let's look at an example of a protected short sale.

BVF is trading at $20, and an investor is bearish.  The investor decides to arrange for a short sale and sells 1000 shares of BVF at $20.   To provide some protection the investor also sells 10 BVF $15 Puts @ $1.50. The investor receives $1,500.00 in option premium into the account.  The $1.50 in option premium acts to increase the breakeven on the trade from $20 (the price at which the stock was sold), to $21.50 (the price the stock was sold plus the option premium received).  Should the stock move against the investor, in this case to the upside, the investor's breakeven point on the trade is $21.50.  Should the stock move to the downside, the investor's maximum gain potential is the difference in strike prices, plus the option premium received.  In this case, that works out to $20-$15+$1.50=$6.50 or $6,500.00. 

Margin is required on this trade and the investor needs to use trading discipline if the trade moves in the wrong direction (up).  The investor may want to use the breakeven as a point to re-evaluate the trade should the stock move to that level.  This is because, above the breakeven, the investor has unlimited risk.