NaughtyPines
Short

THE BEARISH SIDE OF COVERED -- COVERED PUTS

NASDAQ:COST   COSTCO WHSL CORP NEW
If you ever do a little research on the internet about various options strategies, you'll inevitably come across a wide variety of covered call screeners. This is because a covered call strategy is usually about taking a buy and hold position in an underlying, using short calls to reduce cost basis in the position. Additionally, covered calls are permitted in certain investment vehicles, while covered puts are not (since you're shorting the underlying in the case of a covered put, and this is something you generally cannot do, for example, in an IRA environment).

In any event, as compared to a covered call, which takes a long position in an underlying in tandem with a short call option position, covered puts take a short position in the underlying equity and a short put option position. It is a bearish assumption play.

Here is an example (which I'm not going to play; it's just to show you what the setup is like).

COST is currently within 5% of its 52 week high and an earnings announcement is nigh. I'm looking for a potential bounce in advance of earnings or thereafter and then a small profit-taking retracement which I want to take advantage of (so I naturally want to wait to see how earnings goes and catch price at the top of the bounce, and then short via covered put from there, so these prices are unlikely to be what I'd use ... .).

COST -100 Shares @ 166.79
Sell 1 Dec 24 165 short put (currently 2.34 at the mid price)
Entire setup for a 168.84 credit

One thing you'll see here is that by doing this over just shorting COST at 166.79, my breakeven point in the underlying short position is increased to 168.84 (excluding fees/commissions) -- by getting a 2.34 credit for the short put. This increases the likelihood of my closing the position in profit since I'm ahead of the game with the setup to the short side by 2.34, and if price is below 165 at expiration, I realize $384 in profit (you can naturally take the trade off earlier if it's profitable, since break even is anything below 166.78).

As with anything, there are drawbacks to a covered put play. Like covered calls, they tie up a good deal of buying power (you do, after all, have to take a 100 share short position per short put contract), so you may want to be picky with this kind of play.

Additionally, there is the possibility that price will continue to move against your short position, and you do not want to get caught in some awful KBIO             "white swan" event, where price moves some 1000% against your short. In other words, you probably want to stick to underlyings that are generally not subject to that kind of price explosion (e.g., AAPL             is probably not subject to that kind of movement; a biopharma penny stock , well, that's a whole different story) as well as to underlyings that are already at price extremes (all time highs, 52-week highs), such that modest profit taking might emerge ... .
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