|Covered Put Construction|
|Short 100 Shares|
Sell 1 ATM Put
Profit for the covered put option strategy is limited and maximum gain is equal to the premiums received for the options sold.
The formula for calculating maximum profit is given below:
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.
The formula for calculating loss is given below:
The underlier price at which break-even is achieved for the covered put position can be calculated using the following formula.
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.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
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.
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