A covered put is a stock put option that is written (i.e., created and sold) by a person who also is short (i.e., has borrowed and sold) a sufficient number of shares of the stock to cover the option if necessary. In most cases this means that the put writer is short at least 100 shares of the stock for every put written on that stock.
The put option, as explained in the article on option basics, grants the holder the right to sell a security at a specific price. The writer of the put option receives a premium and agrees to buy shares if the option is exercised. For an explanation of what it mans to borrow and sell shares, please see the FAQ article on selling short.
Note the difference between selling something in an opening transaction and selling something in a closing transaction. When you sell a put you already own, you are selling to close a position. When you sell a put you do not own, you are selling to open a position. So when you sell a put in an opening transaction (you give an instruction to your broker “Sell 1 put to open”), that is known as writing the put. You might compare this with selling stock short, where you are selling to open a position.
If you write a naked put, and the stock price goes way way down, you have incurred a significant loss because you must buy the stock at the strike price, which (in this example) is well above the current price.
If you write a covered put, that is you hold a short position on the underlying stock, then past the strike price the put is covered. For every dollar the stock price goes down, the cost to you of getting put (i.e., of buying the shares because the option gets exercised) is exactly offset by the decrease in the stock you hold short. In other words, for the covered put writer, the shares s/he is put balance the shares s/he will have to deliver to close out the short position in those shares, so it balances out pretty well. The put is covered.
Like the covered call, the covered put does not do a thing to protect you against the rise (in this case) in price of the underlying stock you hold short. But if the price of the stock rises, the put itself is safe. So the put writer is covered from loss due to the put.
While the covered-put writer has no risk of losing huge amounts of money due to writing the put, there is the risk of missing out on large gains, as well the risk of a loss due to the short stock position. The risk of missing gains is pretty simple: if a stock has a large fall in price, and puts are nearing expiration with a strike price that is even slightly in the money, those puts will be exercised before they expire. I.e., the covered put writer will be forced to buy shares (known as “being put”). The risk associated with the short stock position is that the shares will rise in price; also see the FAQ article about shorting stock for a full discussion of the risks that come from being short.
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Contributed-By: Art Kamlet, Chris Lott