"Winning stock traders have rules and a well-thought-out plan."


— Mark Minervini

Introduction to Covered Puts

Welcome to Topic #5: Covered Puts! Unlike other topics where we start with a creative or fun graphic, we’re diving straight into the strategy, building on our previous discussion about diagonal strategies. Specifically, we’ll explore one of my favorite approaches: letting the short strike get exercised and understanding the position it places you in.

Core Concept of Covered Puts

Covered puts are essentially the reverse of covered calls. Here's how it works:

1. Initial Setup:

• • Start with a long-term leap option, such as a call, which serves as protection.
  • Sell shorter-term call options (or puts, if transitioning) against the long-term option to generate weekly or periodic income.

1. What Happens if the Short Strike is Exercised?

• • When the stock price moves above the sold strike price, you’ll get exercised, resulting in a short position on the stock.
  • This isn’t necessarily a problem because you can now transition to selling puts week after week to generate income while maintaining your long-term protection.

Practical Example: BITO

Using BITO as our case study:

• Initial Trade Setup: Sold a $26 strike call option while holding a longer-term call (leap). This generated premium but also carried the risk of getting exercised.
• Outcome: BITO’s price surged well beyond $26, resulting in an exercised short position. While the stock price rose quickly, we adapted by selling weekly puts, creating consistent income until the short position was covered.
• Result: The leap option’s gains outweighed the losses from the short stock position, making this strategy profitable overall. However, if a massive upward move is anticipated, it may be better to hold onto leaps without selling short-term options.

Strategy Benefits

1. Income Generation:
   1. Covered puts allow for weekly or periodic income through the sale of options.
2. Flexibility:
   1. You can switch between selling calls and puts depending on your position (short or long).
3. Protection:
   1. The leap option acts as a safety net, ensuring that even adverse moves in the stock price can be managed profitably.
4. Adaptability:
   1. In volatile or fast-moving markets, adjust your strike prices to maximize the likelihood of covering short positions or avoiding further adverse outcomes.

Key Considerations

• Market Expectations: If a stock is expected to make a significant move (up or down), adjust your strategy accordingly. For example:
  • Anticipating a big drop? Close out your leap.
  • Expecting a sharp rise? Avoid selling short-term options.
• Risk Management: Always manage your positions with good money management principles. Selling options guarantees time decay in your favor, but you must monitor and adjust positions as needed.

Summary

Covered puts are an income-generating strategy that works particularly well in markets with orderly movements. They are a useful extension of the diagonal strategy, especially when coupled with leap options for protection. By selling options consistently and managing positions effectively, this approach can yield profitable results over time.

Remember, adaptability and risk management are key to successfully implementing this strategy. The time decay on sold options is always your ally, helping to generate income even in challenging market conditions.

As an additional resource, there is a video covering this entire topic which may include some additional content. Click below to view it.