Covered Put

This strategy is used to arbitrage a Put that is overvalued because of its early-exercise feature.  The investor simultaneously sells an in-the-money Put at its intrinsic value and shorts the stock, and then invests the proceeds in an instrument earning the overnight interest rate.  When the option is exercised, the position liquidates at breakeven, but the investor keeps the interest earned.

Market Outlook

Moderately bearish to bearish sentiment among market participants.

When to Use

An investor often employs a covered put strategy to earn interest income on zero initial outlay.

Profit & Loss Chart

Benefit

The idea is to sell the stock short and sell a deep-in-money Put option at intrinsic value based on the short sale price.  This will generate cash equal to the option’s strike price, which can be invested in an interest bearing asset.  Assignment on the Put option, when and if it occurs, will cause complete liquidation of the position.  The profit would then be the interest earned on what is essentially a zero outlay.  The danger is that the stock rallies above the strike price of the Put, in which case the risk is open-ended.

Risk & Reward

Maximum Profit: Limited
Maximum Loss: Unlimited

Since the Put is deep in-the-money, the maximum gain is limited to interest on initial cash received. The best that can happen is for the stock price to remain well below the strike price, which means the option will be exercised before it expires and the position will liquidate.  The profit/loss from the stock is the sale price less the purchase price, i.e. where the stock was sold short minus the strike price of the option.  Add to that the premium received for selling the option and any interest earned.  Bear in mind that a Put’s intrinsic value is equal to the strike price minus the current stock price.  So if the option was sold for its intrinsic value with regard to where the stock was sold short, exercise of the option results in zero profit/loss (excluding any interest earned).

The maximum loss is unlimited. The worst that can happen at expiration is that the stock price rises above the strike price.  At that point the Put option drops out of the equation and the investor is left with a short stock position in a rising market.  Since there is no absolute limit to how high the stock can rise, the potential loss is also unlimited.  An important detail to note: as the stock rises, the strategy actually begins to incur losses when the delta of the option starts declining (in absolute terms).

Break Even Point

The investor breaks even if the buyer of the Put option exercises immediately.  In that case, the option ceases to exist and the short stock position will also be closed out.  Should the investor be assigned the same day, cash received from the short sales would be paid out right away, so there would be no time to earn any interest.  The assigned stock will be transferred directly to cover the short.

Volatility Changes

Increase In Volatility: Negative Effect
Decrease In Volatility: Effects Vary

Time Decay (Theta)

Positive Effect