Buying and selling shares is not the only way to earn from the equity markets. You can also trade in the derivatives segment to generate additional profits. Derivatives are financial instruments whose value increases or decreases based on the price movements of the underlying securities. The two most common equity derivatives are Futures and Options (F&O).
Trading in F&O allows you to make significantly higher profits with limited capital. However, derivatives trading, more specifically options trading, involves significant risks.
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That being said, there are several strategies you can use to earn profits from derivatives trading while ensuring minimum losses. One such strategy is the covered PUT strategy.
But do you know what this strategy is? How does it work? And how can you utilize it to make money from the derivatives market? Continue reading to find answers to all such questions.
When you know the covered call strategy, understanding covered PUT should not be much more difficult. Just that you have to deal with the PUT Option here rather than the Call Option. You can use a covered call strategy when you think the market will remain neutral to bullish in the short term. In contrast, a covered PUT helps if you feel the market can show a neutral to bearish trend in the near term.
The covered PUT strategy involves two steps. First, you have to short-sell the shares of a company, expecting its price to fall in the future. Then you can then sell a PUT option against the stocks you have already shorted. In return, you receive a premium from the buyer of the PUT option.
Short-selling shares allow you to make a profit from the falling market. It allows you to sell and re-buy the shares when they fall to your target price. This target price should be the strike price for the PUT option. The buyer of the PUT option will get the right (but not an obligation) to buy shares from you at a strike price before the expiry date.
Now, if the share price falls below the strike price of the PUT option you’ve sold, the buyer will exercise his option to purchase shares from you at the strike price, which is any way your target price to repurchase the shares. This way, you can make double profits by closing your short position and the premium you’ve received from the buyer of your PUT option.
Now, let’s understand how the covered PUT strategy works with the help of an example. Suppose the shares of a company - ABC are currently trading for Rs. 100 per share, and you strongly believe their price will fall soon. So, you enter into a short position by short-selling these stocks, hoping to re-buy them once they fall to your target price of Rs. 80 per share.
But after you’ve taken a short position, you feel that the share may not decline as much. So, you decide to use the covered PUT strategy and sell a PUT option for a strike price lower than the price for which you’ve short-sold the shares, i.e., Rs. 80. As the seller of the PUT option, you will receive a premium from the buyer.
Now, your profit under the three possible scenarios would be as follows:
In this scenario, you will make profits by buying back the shares you’ve shorted and can also keep the premium you’ve received from the buyer of the PUT option.
In this scenario, you will incur a loss as the price of the shares has moved in the opposite direction. However, you can still keep the premium you’ve received from the buyer of the PUT option.
You will neither gain nor lose from your short position in this scenario. However, the premium from the PUT option buyer will remain with you.
Hopefully, now you understand what a covered PUT strategy is and how you use it to gain from the stock markets. But it’s advisable to make your moves carefully after analysing the involved risks. If you need a Demat account to invest, you can get it for free with Motilal Oswal.
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