Last Update: August 2021

Cash flow seekers just love the covered call. And why shouldn’t they? It boasts a litany of advantages from cost basis reduction and probability of profit elevation to downside protection and income generation. Not to mention its ability to generate superior risk-adjusted returns over time.

But what if the market turns bearish? While some starry-eyed novices may believe bear markets belong in the same category as unicorns and leprechauns, I assure you they are real. And whether it’s this year or the next (or the next), it will strike. But here’s the deal. Even though the S&P 500 may not have officially tagged the 20% decline mark during any of its tantrums in recent years, that doesn’t mean there aren’t individual sectors or stocks that haven’t entered bear country.

Have you seen energy stocks lately? They’re in a bear market. XLE is down 19% and XOP is down 33%. And what about retail? XRT is down 20%. There’s always a bear market somewhere.

So do the bears have a cash flow producing equivalent to the covered call?

YES!

It’s known as a Covered Put.

And, as you might imagine, its structure is the exact opposite of the covered call. Instead of buying 100 shares of stock, you short 100 shares of stock. Instead of selling a call option, you sell a put option. Instead of your cost basis being lowered, your cost basis is increased (which is a good thing for a short stock position).

So, you short 100 shares and sell a put. Let’s look at an example using downtrodden energy stocks. Suppose we think the descent in XOP is destined to continue. We could short 100 shares at the current price of $30.30. Then, we could sell a short-term, OTM put option. Say we sell the July $30 put for $1. By selling the put, we obligate ourselves to buy to cover the stock at $30. That limits our potential profit on the short stock position, but we get a host of benefits. Consider these key metrics:

• Cost Basis: $30.30 + $1 = $31.30
• Breakeven: $31.30
• Amount of Protection afforded by the short put: $1
• Potential Reward: $1.30 ($1 put premium + 30 cents potential profit on short stock)
• ROI: 4.3% ($1.30 / $30.30)

I used the entire stock value for the cost in the ROI calculation. The reality is your broker may hold aside far less for a short stock trade. If so, your ROI would be even higher. In ThinkorSwim you can see the cost (i.e. buying power effect) in the order preview window before placing the trade.

To create the order, you simply right click on the put you want to sell and select “Sell” and then “Covered Stock.” It should bring up an order that simultaneously sells stock and sells a put. Here is a risk graph of the position. Notice how it is the mirror image of the covered call risk graph

The best-case scenario is to have XOP drift lower and sit below the short put strike ($30) at expiration. If XOP trades sideways, the put value will incrementally lose value due to time decay. There’s really no need to reinvent the wheel with this. Most traders should probably just follow the same rules and logic they use for managing their covered call positions.

So give it a shot. Paper trade a few covered put plays and see what you think!

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