Writing covered puts is a bearish options trading strategy involving the writing of put options while shorting the obligated shares of the underlying stock.
Short 100 Underlying, Sell 1 ATM Put
Limited profits with no downside risk
Profit for the covered put option strategy is limited and maximum gain is equal to the premiums received for the options sold.
Premium Received - Commissions Paid
Profit achieved when: Price of Underlying <= Strike Price of Short Put
Unlimited upside risk
As the writer is short on the stock, he is subjected to much risk if the price of the underlying stock rises dramatically. In theory, maximum loss for the covered put options strategy is unlimited since there is no limit to how high the stock price can be at expiration. If applicable, the covered put writer will also have to payout any dividends.
Unlimited
Loss occurs when: Price of Underlying >= Sale Price of Underlying + Premium Received
Loss = Price of Underlying - Sale Price of Underlying - Premium Received + Commissions Paid
Breakeven point
Sale Price of Underlying + Premium Received
Example
Suppose XYZ stock is trading at $45 in June. An options trader writes a covered put by selling a JUL 45 put for $200 while shorting 100 shares of XYZ stock. The net credit taken to enter the position is $200, which is also his maximum possible profit.
On expiration in July, XYZ stock is still trading at $45. The JUL 45 put expires worthless while the trader covers his short position with no loss. In the end, he gets to keep the entire credit taken as profit.
If instead XYZ stock drops to $40 on expiration, the short put will expire in the money and is worth $500 but this loss is offset by the $500 gain in the short stock position. Thus, the profit is still the initial credit of $200 taken on entering the trade.
However, should the stock rally to $55 on expiration, a significant loss results. At this price, the short stock position taken when XYZ stock was trading at $45 suffers a $1000 loss. Subtracting the initial credit of $200 taken, the resulting loss is $800.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.
Naked Call Writing
An alternative but similar strategy to writing covered puts is to write naked calls. Naked call writing has the same profit potential as the covered put write but is executed using call options instead.