What Are Covered Puts and How Do They Work?
Explore covered puts, a strategic options approach for income generation or stock acquisition with defined risk.
Options are financial contracts that derive their value from an underlying asset, such as a stock. Among the various options strategies available, covered puts represent a specific approach that combines the selling of a put option with a financial safeguard. This strategy allows an investor to potentially generate income or acquire shares of a company at a desired price, while managing the associated obligations. Understanding the mechanics of covered puts involves comprehending the nature of put options and the meaning of being “covered” in this context.
Understanding Put Options
A put option is a financial contract that grants the holder the right, but not the obligation, to sell an underlying asset at a predetermined price, known as the strike price, on or before a specified date, which is the expiration date. For the individual who sells, or “writes,” a put option, this contract creates an obligation to purchase the underlying asset if the option buyer chooses to exercise their right. This dynamic establishes a clear buyer-seller relationship where one party gains a right and the other assumes a corresponding obligation.
Several components define a put option. The “underlying asset” refers to the specific security, often a stock, to which the option contract is tied. The “strike price” is the fixed price at which the underlying asset can be sold or bought, irrespective of its market price at the time of exercise. The “expiration date” marks the final day on which the option contract remains valid; after this date, the option becomes worthless if not exercised. Finally, the “premium” is the amount of money the buyer pays to the seller for acquiring the put option contract, representing the value of the right conveyed.
Defining the “Covered” Aspect
The term “covered” in the context of a covered put specifically refers to the seller’s financial capacity to fulfill their obligation if the put option is exercised. For a put to be considered “covered,” the seller must hold sufficient liquid capital, typically cash, in their brokerage account. This cash is explicitly set aside to purchase the underlying shares at the strike price if the option buyer decides to exercise their right to sell. This ensures that the seller can meet their contractual commitment without relying on borrowed funds or facing a default.
Brokerage firms typically require that the full cash amount needed to purchase the shares at the strike price remains in the account for the entire duration of the put contract. This reserve of funds reduces the investor’s available cash for other transactions or withdrawals. While a covered put can also technically involve holding a short position in the underlying stock, having cash collateral is the more prevalent and understandable scenario.
Mechanics of a Covered Put Transaction
The process of a covered put transaction begins when an investor, acting as the seller or “writer,” sells a put option. Upon selling the option, the seller immediately receives the premium from the buyer. This premium is a direct cash inflow to the seller’s account.
The core of the seller’s commitment lies in their obligation to purchase the underlying shares at the agreed-upon strike price if the option is exercised by the buyer. This obligation remains active until the expiration date. If the option expires without being exercised, the seller retains the entire premium received, which is then recognized as a short-term capital gain for tax purposes.
Two primary scenarios can unfold at or before the option’s expiration. If the underlying stock’s market price remains above the strike price at expiration, the put option will expire “out-of-the-money” and become worthless. In this favorable outcome for the seller, no shares are exchanged, and the seller profits solely from the collected premium.
Conversely, if the underlying stock’s market price falls below the strike price, the option is considered “in-the-money,” and the buyer may exercise it. When the option is exercised, the seller is “assigned,” meaning they are obligated to purchase 100 shares of the underlying asset per option contract at the strike price. The cash set aside in the brokerage account is then used to complete this purchase. For tax purposes, if a put option is exercised, the premium received by the seller is used to reduce the cost basis of the shares acquired. The holding period for these newly acquired shares begins on the date of purchase, not the date the put was written, which affects whether future gains or losses on these shares are considered short-term or long-term capital gains when they are eventually sold.