How to Sell a Covered Put Step by Step

Options trading offers various strategies to manage investments and generate income. Selling a covered put is one such strategy, allowing investors to acquire shares at a specific price or earn income. This article covers understanding, preparing for, executing, and managing a covered put position.

The Covered Put Strategy

A covered put option involves an investor selling a put option while holding enough cash to purchase the underlying shares if assigned. The “covered” aspect means the investor has the financial capacity to fulfill this obligation. This strategy aims to generate income through the premium received or to acquire shares of a company at a desired strike price. If the stock price falls below the strike price by expiration, the seller must buy the shares at that price. The premium received reduces the cost basis of the shares if assigned.

Core components include the underlying stock, the put option contract, the strike price, and the expiration date. Each option contract represents 100 shares of the underlying stock. The seller receives an upfront premium for the obligation to buy shares if the put option finishes in the money.

Having cash readily available limits risk to the difference between the strike price and the premium received, should the stock price drop. This contrasts with selling an uncovered or “naked” put, which carries higher risk.

Preparing to Sell a Covered Put

Before trading options, establish an options-enabled brokerage account. Firms require specific approval levels, often Level 1 or 2 for cash-secured puts, demonstrating an understanding of risks and sufficient financial resources.

Allocate the full cash amount needed to purchase the underlying shares. For example, a $50 strike price requires $5,000 (100 shares x $50). This cash acts as collateral, ensuring you can fulfill your obligation if the put option is exercised. Brokerage firms reserve these funds, preventing their use for other investments while the option is open.

Analyze the underlying stock before selecting a put option. Research the company’s fundamentals, financial health, industry outlook, and management. Understanding the stock’s volatility helps in making informed decisions.

Select a strike price and an expiration date. Investors often choose an out-of-the-money (OTM) strike price, below the current market price, to increase the likelihood of the option expiring worthless. An at-the-money (ATM) strike price, close to the current market price, yields a higher premium but has a greater chance of assignment.

The main risk is the stock price falling below the chosen strike price, leading to assignment at a higher price than the current market value. This can result in an unrealized loss on the acquired shares, even after accounting for the premium.

Placing the Covered Put Order

After preparation, place the order through your brokerage platform. Navigate to the options trading section, select the desired underlying stock, and choose the specific put option.

Specify the expiration date and strike price from the options chain. The platform will display current bid and ask prices.

Enter the number of contracts to sell. One contract represents 100 shares. Use a limit order to specify the minimum premium you will accept, providing control over the execution price. Market orders execute immediately but may not be optimal.

Review all order details before submitting, including the underlying symbol, option type, strike price, expiration date, number of contracts, limit price, and any commissions. Brokerage commissions vary.

Once confirmed, the order is sent for execution. After it fills, the premium is credited to your account, typically within one to two business days. This credit reduces the cash held as collateral.

Managing and Closing a Covered Put

After the order is filled, monitor the position by tracking the underlying stock price and the put option’s value. As expiration nears, the option’s time value erodes (theta decay), which benefits the seller if the stock price stays above the strike.

If the stock price remains above the strike at expiration, the put option expires worthless. The investor keeps the entire premium received, and no shares are assigned. This is the maximum profit for the strategy, limited to the collected premium.

If the stock price falls below the strike at or before expiration, the put option may be assigned. Assignment obligates the investor to purchase 100 shares per contract at the specified strike price. For instance, if a $50 strike put is assigned when the stock is at $45, the investor buys shares at $50, incurring an unrealized loss before accounting for the premium.

Investors can close their position early by “buying to close” the option before expiration. This involves buying back the sold option. Reasons to close early include:
Locking in most premium profit when the option’s value decreases.
Freeing up collateral cash.
Cutting losses if the stock price falls.
Avoiding potential assignment.

If assignment occurs, the investor receives 100 shares per contract at the strike price. They can then:
Hold the stock, anticipating a future price increase.
Sell the stock at the current market price.
Implement another options strategy, like selling covered calls.

Tax implications: Premium received is generally treated as short-term capital gains if the option expires worthless. If assigned, the premium reduces the cost basis of the acquired shares, and tax implications arise when those shares are sold, subject to capital gains rules.