Up until now we have been discussing selling uncovered puts. We don’t have a position in the underlying stock (as in writing covered calls). If you wanted to sell covered puts, you could, now or later, sell short the stock. You could generate cash, ride the stock on down, and when the stock falls in price (which is your risk in selling puts) you could cover your position by being short on the stock. If the stock gets put to you, it will cover (end) your short position.
Remember, you’ve agreed to buy stock you don’t own. Now you’ve borrowed stock you don’t own—you’re covered. Sounds crazy, doesn’t it?
Think of it this way. If you have to purchase the stock at $15, and your broker immediately sells 1,000 shares in a short sale, your obligation is covered. Now if there is a dip in the stock price, the stock you buy (at this lower wholesale price) will cover your short position.
This is a hedge. Now, let’s double hedge. You hedge a short sale by purchasing call options. If the stock is at $13 and you still think there will be an increase, buy a $15 call option. Now you have the right to buy the stock at $15. The risk of short selling is an increase in the stock price. With the $15 call options, you’ve purchased insurance.
If the last several paragraphs frustrate you, read them again, discuss them with your broker, and don’t worry too much. I’ve sold dozens and dozens of puts. I’ve only had to do short sales a couple of times. If you do your homework, and then sell the puts when the stock is way down and rising, you won’t have to worry about this.
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