Covered short put
Also written Covered short put position
Writing a put option while holding enough funds to buy the commodity if the put is exercised — a premium-earning strategy, as opposed to a naked short put written without the funds.
In plain language
Selling a put means accepting an obligation: if the buyer exercises, you must buy the commodity at the strike. You are paid a premium for taking that obligation on.
A covered short put is that trade done with the money to honour it already set aside. The workbook calls it a hedging strategy that attempts to enhance the return on funds. The same trade without the funds is a naked short put — which the workbook classifies as speculative.
The writer's best outcome is modest and fixed: the put expires unexercised and he keeps the premium. His risk is a large fall in price, only partly cushioned by that premium.
How it works
Construction. Sell a put; hold sufficient funds to buy the commodity if required (Chapter 5, section 5.7.1).
Payoff at expiry, per unit:
If price at expiry >= strike: profit = premium
If price at expiry < strike: profit = premium - (strike - price)
Break-even price = strike - premium
Choosing the strike. The intention is to earn premium while reducing the risk of exercise, so the workbook says an out-of-the-money strike is chosen. The further OTM, the lower the chance of exercise — and the lower the premium.
Covered versus naked, call versus put:
| Position | Built from | Workbook label |
|---|---|---|
| Covered short call | Long underlying + short call | Enhances return in a stagnant market; partially hedges the long |
| Naked short call | Short call, no commodity owned | Speculative |
| Covered short put | Short put + funds to buy | Enhances return on funds |
| Naked short put | Short put, no funds | Speculative |
Margins. Whatever the cover, a put writer in exchange-traded commodity options pays the Short Option Minimum Margin (SOMM), and if it is an option on goods that ends up ITM or CTM, delivery period margin.
A worked example
The workbook's trade. Gold is at Rs 50,000 per 10 g. An investor sells a Rs 50,500 put for a premium of Rs 600 and keeps enough funds to buy gold if assigned.
Break-even = 50,500 - 600 = Rs 49,900
Outcomes at expiry, per 10 g and on a 1 kg lot (100 x 10 g, illustrative):
| Price at expiry | Put intrinsic value | Net per 10 g | Net per 1 kg |
|---|---|---|---|
| 51,000 | 0 | +600 | Rs 60,000 |
| 50,500 | 0 | +600 | Rs 60,000 |
| 50,000 (unchanged) | 500 | +100 | Rs 10,000 |
| 49,900 | 600 | 0 | nil |
| 49,000 | 1,500 | -900 | Rs -90,000 |
The most he can make is the premium. Below Rs 49,900 every Rs 100 fall costs him Rs 100 per 10 g, and the only thing standing between him and that loss is the Rs 600 already collected.
The cover matters on assignment. At Rs 49,000 he must buy 1 kg at Rs 50,500 per 10 g — Rs 50,50,000. The covered writer has that money. The naked writer has to find it or default.
Why NISM asks about it
Chapter 5, section 5.7.1 (Covered Option Position), sets out the covered short call and covered short put, with the nickel and gold examples and the reasoning for choosing OTM strikes. Expect a scenario on the outcome at a given expiry price, the difference between covered and naked positions, and why a more OTM strike lowers both the premium and the risk of exercise.
Common exam traps
- The workbook's example contradicts its own rules — check the arithmetic, not the prose.
- It says an OTM strike is chosen, but a Rs 50,500 put with gold at Rs 50,000 is in the money by Rs 500.
- It says that if the price "remains stagnant" the put will not be exercised. At Rs 50,000 the put is still ITM by Rs 500; the writer nets Rs 100, not the full Rs 600.
- The Rs 49,900 case (net zero) and the "Rs 50,600 or above" case (keep Rs 600) are correct.
- The workbook also describes the position two ways: "holding sufficient funds to buy the commodity" and "partially hedge a short underlying position". The worked example is the cash-covered version.
- Maximum profit is the premium; the loss grows as price falls below the break-even.
- Covered put = short put + funds. Do not confuse it with a covered call (long underlying + short call).
- A naked short put is speculative in the workbook's classification.
- More OTM = lower premium and lower chance of exercise, never higher premium.
Check yourself
1.How does the workbook distinguish a covered short put from a naked short put?
- a)A covered short put is written by someone who holds the commodity; a naked short put is written by someone who holds cash
- b)A covered short put is created by selling a put while holding sufficient funds to buy the commodity if necessary; selling a put without funds is a naked short put, which is a speculative position
- c)A covered short put uses an in-the-money strike; a naked short put uses an out-of-the-money strike
- d)There is no difference; both are hedging strategies
Show the answer
Answer: (b) A covered short put is created by selling a put while holding sufficient funds to buy the commodity if necessary; selling a put without funds is a naked short put, which is a speculative position
"A COVERED SHORT PUT position is a hedging strategy and is created when the investor is SELLING A PUT OPTION AND AT THE SAME TIME HOLDING SUFFICIENT FUNDS TO BUY THE COMMODITY, if necessary... A covered short put position is different from naked short put position. SELLING A PUT OPTION WITHOUT FUNDS IS CALLED 'NAKED SHORT PUT POSITION' WHICH IS A SPECULATIVE POSITION."
The logic: a put writer is obliged to buy if the put is exercised. What covers that obligation is cash, not the commodity.
Why the other options are wrong:
- (a) mixes it up with the covered call. A covered call is covered by holding the commodity: "combining a long underlying position with a short call option."
- (c) Cover means having the resource to meet the obligation. It has nothing to do with the strike chosen. In practice the workbook advises an out-of-the-money strike "so that the chances of it being exercised remains low."
- (d) Only the covered version is a hedging strategy. The naked version is speculative.
2.What distinguishes a covered short call from a naked short call?
- a)A covered short call uses an in-the-money strike; a naked short call uses out-of-the-money strikes
- b)In a covered short call the writer holds a long position in the underlying commodity; in a naked short call he does not own the commodity
- c)A covered short call requires no margin; a naked short call does
- d)A covered short call can only be written on options on goods
Show the answer
Answer: (b) In a covered short call the writer holds a long position in the underlying commodity; in a naked short call he does not own the commodity
"A COVERED SHORT CALL POSITION IS CREATED BY COMBINING A LONG UNDERLYING POSITION WITH A SHORT CALL OPTION." And the contrast: "Covered short call is DIFFERENT FROM A NAKED SHORT CALL. A NAKED SHORT CALL IS A SPECULATIVE POSITION WHERE THE INVESTOR DOES NOT OWN THE COMMODITY."
The difference is not cosmetic. Recall from the options chapter that a short call carries unlimited risk. For a covered writer, assignment simply means delivering stock he already owns — his real cost is forgone upside, not loss. For a naked writer, assignment means buying at whatever the market demands in order to deliver.
The strategy's purpose: it "attempts to ENHANCE THE RETURN IN A STAGNANT MARKET and at the same time PARTIALLY HEDGE A LONG UNDERLYING POSITION." In the workbook's nickel example, a holder of 500 kg with spot at Rs 1,000 writes a Rs 1,025 call for Rs 12 — and if nickel falls to Rs 990, the premium "partly compensates the fall in the value of the spot position."
The same distinction applies on the put side: a covered short put means selling a put while holding sufficient funds to buy the commodity if necessary, whereas "selling a put option WITHOUT FUNDS is called a NAKED SHORT PUT POSITION, which is a speculative position."
Option (a) inverts the strike guidance — a covered writer is advised to "go for a little out of money strike so that the chances of it being exercised are low."
Where this is taught
Free preparation for NISM Series XVIRelated terms
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
- MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.
- Covered callHolding the underlying in the cash market and writing a call against it — a way of earning premium income from a holding, at the cost of capping the gain above the strike.
- Option premiumThe price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.
- Option writerThe party who sells an option: receives the premium upfront and takes on the obligation to sell (call) or buy (put) the underlying if the buyer exercises. Gain is capped at the premium.
- Short Option Minimum MarginThe SPAN-computed margin charged to the writer of a commodity option, floored by SEBI-prescribed minimum volatility scan ranges so that a cheap option cannot be written on a trivial margin.