Covered Writes: Puts
When considering covered writes, most traders think of selling a call against a long position in the stock, with the object of gaining the call’s premium over intrinsic value. However, you also can write puts with the same object. Of course, if you sell a put, you have a long position, and the hedging leg of the write must be a short position, either in the stock or an equivalent.
The up-tick rule (which prevents the short sale of a stock unless the last trade was higher than the previous trade) may interfere with your timing on this transaction and make it impossible to take a short position in the stock when you want to. Or, you may not be able to locate any stock to borrow for your sale. There are several ways around these problems.
The simple solution is to purchase a deep in-the-money (ITM) put, which will behave essentially like a short position in the stock. For a slightly more complicated solution, you can create a synthetic short.
Recall that a synthetic short consists of a long put and a short call with the same strike price and expiration. If you cannot find a deep ITM put that suits you for your covered write, look through the strikes and expirations for a favorable synthetic short.
As I explained in a previous commentary, the puts and calls with the same expiration and strike price will have roughly equivalent implied volatilities, so you will not gain much of an edge buying one and selling the other. But you still should favor a strike and expiration where the put has a lower implied volatility than the call, even if the difference is small.
If you choose a synthetic with strike price close to the current stock price, you will essentially be spreading one put against the other, with a short call for seasoning. This gets into the area of complex spreads, a topic for further discussion; I would recommend for now that you stick to strike prices that make the put at least moderately ITM. Also, if the put is moderately ITM, the call will be moderately OOTM and there is a smaller chance you will have to contend with its exercise.
The synthetic short has two important advantages over a short stock position. First, you can execute it with certainty and instantaneously. Second, the margin on the synthetic short will be less than the margin on the short stock position.