Lesson 3 of 4
This strategy involves selling a put option and being short an equivalent amount of the underlying stock.
Covered Put Construction: Short 100 stocks + Short put option
When the stock drops, the put option will be exercised and the investor will get the stock at the short put strike price. This will cover the obligation of the shorted shares. The investor keeps the premium received from selling the put option. If the stock rises the investor still keeps the premium, but the put option will expire worthless. The investor is still holding the short stock obligation and could sustain a loss to close the short position.
Market Outlook: This strategy is useful if the trader has a neutral to slightly bearish market outlook. This is because the trader is expecting the stock to go down or stay neutral
Risk: Maximum loss is unlimited. Since the trader is short the stock, he is at risk if the stock price rises. The maximum loss for the covered put options strategy is unlimited as the stock prices can rise infinitely.
Reward: Limited. Profit for the covered put option strategy is limited and maximum gain is equal to the premiums received for the options sold.
Break Even Point: Sale Price of Underlying + Premium Received
An investor is short 100 shares of ABC stock, valued at $10,000. He sells 1 put option contracts (in the US, 1 option contract covers 100 shares) for $300 with a strike price of $97. The payoff from the strategy can be shown as follows:
| Stock Price at Option Expiry | Position Profit / (Loss) at Expiry |
| 90.00 | 600.00 |
| 91.00 | 600.00 |
| 92.00 | 600.00 |
| 93.00 | 600.00 |
| 94.00 | 600.00 |
| 95.00 | 600.00 |
| 96.00 | 600.00 |
| 97.00 | 600.00 |
| 98.00 | 500.00 |
| 99.00 | 400.00 |
| 100.00 | 300.00 |
| 101.00 | 200.00 |
| 102.00 | 100.00 |
| 103.00 | - |
| 104.00 | (100.00) |
| 105.00 | (200.00) |
| 106.00 | (300.00) |
| 107.00 | (400.00) |
| 108.00 | (500.00) |
| 109.00 | (600.00) |
| 110.00 | (700.00) |
