How to Sell Covered Puts

Selling covered puts is an options trading strategy to manage risk and generate income. This guide explains its mechanics, preparation, execution, management, and tax implications.

Understanding Covered Puts

A covered put strategy involves selling a put option while simultaneously holding sufficient cash or cash equivalents to purchase the underlying shares if assigned. A put option grants its holder the right, but not the obligation, to sell 100 shares of an underlying asset at a specified price, known as the strike price, before or on a particular expiration date. When an investor sells a put option, they assume the obligation to buy those 100 shares if the option holder exercises their right.

The “covered” aspect means the seller has the necessary capital in their brokerage account to fulfill the potential obligation of buying the shares. This distinguishes it from a naked put, where the seller lacks this coverage, exposing them to greater risk.

The primary purpose of selling a covered put is to generate premium income. It can also be used to acquire shares of a desired company at a lower effective price if the option is assigned. This strategy differs from a covered call, where an investor sells a call option against shares they already own.

Preparing to Sell Covered Puts

Before initiating a covered put trade, ensure your brokerage account is funded. Most firms require specific approval levels for options trading, often Level 2 or Level 3, which permit selling options. Obtaining this approval involves completing an application that assesses an investor’s trading experience, financial situation, and understanding of options risks. Brokerages use this information to grant trading privileges.

Sufficient capital is required in the account to cover the potential purchase of shares. If a put option with a strike price of $50 is sold, covering 100 shares per contract, the investor must have at least $5,000 set aside. This capital acts as collateral, ensuring the investor can fulfill their obligation to buy the shares if the option is exercised. The brokerage will earmark or “reserve” this amount, reducing the investor’s available buying power.

Thorough research into the underlying stock is important before selling a covered put. Investors should analyze the company’s financial health, recent earnings reports, and any upcoming news or events that could impact its stock price. Understanding the stock’s historical price trends and volatility helps in making informed decisions about appropriate strike prices and expiration dates. This research helps identify companies aligning with long-term acquisition goals or those less likely to decline sharply.

Executing a Covered Put Trade

Once preparatory steps are complete, execute a covered put trade by navigating the brokerage’s options trading platform. Locate the options chain for your chosen underlying stock, which displays various strike prices and expiration dates for both call and put options. Select the appropriate put option by considering both the desired strike price and the expiration date.

The strike price should be below the current market price of the stock, allowing the option to be “out-of-the-money” at sale. This offers downside protection and allows the investor to collect premium without immediate assignment. Expiration date selection depends on the investor’s outlook; shorter-term options (e.g., 30-60 days) experience faster time decay, which benefits the seller, while longer-term options offer more premium but greater exposure to market fluctuations. Choose a strike price at which you would genuinely be willing to purchase the underlying shares.

When placing the order, select “Sell to Open” to initiate a new short options position. A limit order is recommended over a market order for selling options. A limit order allows the investor to specify the exact premium they wish to receive per share, ensuring price control. Once the strike price, expiration date, and limit premium are set, the order can be reviewed for accuracy. Upon submission, the order will remain open until it is filled at the specified limit price or expires.

Managing and Closing Covered Put Positions

After a covered put trade is executed, continuously monitor the position. Investors should regularly observe the underlying stock’s price movements, the put option’s premium value, and the remaining time until expiration. Time decay, often referred to as theta, steadily erodes the value of the option premium as it approaches expiration, which benefits the option seller. However, significant downward movements in the underlying stock price can increase the option’s value, potentially offsetting the benefits of time decay.

To exit a covered put position before expiration, an investor can place a “Buy to Close” order. This involves purchasing the same option contract back in the market. If the option’s value has decreased since it was sold, the investor can buy it back for less than the premium initially received. This strategy allows the investor to lock in gains or cut losses if the stock moves unfavorably. Alternatively, an investor might “roll” the option by closing the current position and simultaneously opening a new covered put position with a different strike price or expiration date, often to extend the trade or adjust the strike.

At expiration, if the stock’s price remains above the put option’s strike price, the option will expire worthless (out-of-the-money). The investor retains the entire premium received and incurs no further obligations.

If the stock price falls below the strike price, the put option will be in-the-money, and the investor will be assigned. Assignment means the investor must purchase 100 shares of the underlying stock per contract at the specified strike price. Upon assignment, the shares will appear in the investor’s account, and the corresponding cash amount will be debited. If the stock price is exactly at the strike price, the outcome can be uncertain, and assignment is still possible.

Tax Implications of Covered Puts

The premium received from selling a covered put option is treated as income. If the option expires worthless, the entire premium is considered short-term capital gain income for tax purposes, as the holding period for most options contracts is less than one year. This income is taxable in the year the option expires.

If an investor closes the covered put position by buying it back before expiration, any gain or loss realized from this transaction is also treated as a short-term capital gain or loss. A gain occurs if the option is bought back for less than the initial premium received, while a loss occurs if it is bought back for more. These gains and losses are aggregated with other short-term capital gains and losses for the tax year.

Should the covered put option be assigned, the cost basis of the acquired shares is adjusted. The basis is calculated as the strike price of the option minus the premium originally received for selling the put. For example, if a put with a $50 strike was sold for a $2 premium and then assigned, the effective cost basis of the shares would be $48 per share. The subsequent sale of these shares will result in a capital gain or loss, which will be classified as short-term or long-term depending on how long the shares were held after assignment. Brokerage firms provide Form 1099-B, which reports the details of options transactions and stock sales.