DESCRIPTION: Generally considered an “income” or “purchase” strategy, where one sells a put option with the expectation it will expire worthless, or they buy the stock at a discount to the existing stock price. If the put option sold is out-of-the-money, income falls but so does the probability the stock will be assigned to the put seller.
MOTIVATION: The investor who employs a covered put writing strategy seeks to increase the income on their cash portfolio by selling a put with the expectation it will expire worthless so they can repeat the process. They may also sell a put as a way of buying the underlying stock at a discount to the current market price. Selling a put has similar downside risks as owning a stock, but has less upside as the best one can do is keep the premium collected. A cash covered put will outperform the underlying stock in flat to bearish scenarios.
OUTLOOK: The investor who sells a cash covered pup is looking for stable or slowly rising asset price over the time to expiration of the put option. This strategy will underperform a holding stock outright in a rising market. It has similar risks as holding the stock outright, but will outperform stock by the premium collected in a bearish scenario.
PROFIT/LOSS: Min(Strike – Asset Price, 0) + Premium Received
The amount one earns at expiration is equal to the strike price of the put option sold less the asset price or zero, plus the initial premium collected, to sell the put. The investor is not entitled to the dividends paid by the company if any, as only shareholders have write to a dividend.
MAXIMUM GAIN: Premium Paid
The most one can earn is the premium collected up front (plus any interest on cash holdings as well)
MAXIMUM LOSS: Strike Price – Premium Received
The maximum one can lose is equal to the value of the strike price less the premium collected on the put option sold. This would occur if the value of the stock goes to zero, which could happen in a bankruptcy scenario. In this case, worthless stock is put to the put option seller at the agreed upon strike price.
BREAKEVEN: Strike Price – Premium Collected
The investors will breakeven at expiration if the asset price falls below the strike price of the put by an amount equal to the premium collected.
VOLATILITY: An increase in implied volatility would have a small negative impact the profitability of a short put position. This impact is relevant if the investor wanted to buy the put back sometime before option expired. An increase in realized volatility increases the probability that the stock will rise or fall substantially in price.
TIME DECAY: Time decay has a positive impact on the performance of a cash covered put selling strategy. In fact, time decay is the reason why people sell puts. Capital market theory tells us that assets are prices with the expectation they will rise in the future. In other words, puts have a negative expected return. Put sellers capitalize on this fact by selling puts they expect to expire worthless.
ASSIGNMENT RISK: Substantial If the stock price falls below the strike price, the shares will be put to the investor at a time when they do not want to own them.
EXPIRATION RISK: Not very much except when at the money. The seller of the put will either continue to own cash equal to the strike price at expiration or end up owning the stock. If the stock is at the money, you will not know if you own the stock until the day after options expiration.
STRATEGY PAIR: The profit/loss payoff profile for a cash covered put strategy strategy is the same as that for the covered call strategy. Put-call parity suggests that stock plus a put is equal to cash plus a call. So cash less a put is equal to call less a stock.