Covered Put Option Strategy

Submitted by admin on Thu, 11/25/2021 - 21:12

Because of its early-exercise characteristic, this approach is utilized to arbitrage a put that is overpriced.

Description


The plan is to short the stock and sell a deep-in-the-money put at a price close to its intrinsic value.
This will result in cash equal to the strike price of the option, which may be put into an interest-bearing asset.
When and if the put option is assigned, the position will be completely liquidated.
The profit would then be the interest on what is basically a zero-dollar investment.
The risk is that the stock rises over the put's strike price, in which case the risk is unlimited.

Outlook


During the option's life, look for a constant to slightly declining stock price.
A longer-term neutral attitude isn't always incompatible with this approach, but a positive long-term outlook is.

Summary


Because of its early-exercise characteristic, this approach is utilized to arbitrage a put that is overpriced.
The investor sells an in-the-money put near its intrinsic value, then sells the stock and invests the profits in an overnight interest-earning instrument.
The position is liquidated at breakeven when the option is executed, but the investor keeps the interest generated.


Net Covered Put Position (at expiration)


EXAMPLE


100 shares of AAPL stock are shorted.

1 AAPL 100 put short


GAIN MAXIMUM


Price of a short sale - strike price + premium received (interest)


LOSS MAXIMUM


Unlimited


Motivation


Earn interest with no upfront investment.

Variations


This article only discusses one form of the approach, which is an arbitrage strategy employing deep-in-the-money puts.
When the aim is solely to generate premium, a covered put strategy might be employed with an out-of-money or at-themoney put.
But, if a covered put strategy has the same reward profile as a naked call, why not utilize the naked call strategy instead of the short stock position?

Maximum Loss


There is no limit to the amount of money you may lose.
The worst-case scenario is if the stock price rises rapidly above the put strike price at expiry.
The put option is then removed from the equation, leaving the investor with a short stock position in a rising market.
The potential loss is likewise endless because there is no ultimate limit to how far the stock may soar.
It's worth noting that when the stock climbs, the method actually starts to lose money as the Delta of the option starts to fall (in absolute terms).

Maximum Gain


The maximum gain is restricted to interest on the initial cash plus any time value in the option when sold since the put is deep in the money.
The best-case scenario is that the stock price stays significantly below the strike price, implying that the option will be exercised before it expires and the position will be liquidated.


The stock profit/loss is equal to the sale price less the purchase price, i.e., where the stock was sold short minus the option strike price.
Add in the premium you got for selling the option, as well as any interest you got.
Keep in mind that the strike price minus the current stock price is the intrinsic value of a put.
Exercise of the option results in zero profit/loss if the option was sold for its intrinsic value in relation to where the stock was sold short (excluding any interest earned).

Profit/Loss


The profit potential is restricted to the interest generated on the short sale money.
When the stock rises significantly, the potential losses are limitless.


This technique, like the naked call, which has a similar reward profile, has a high level of risk and has a restricted earning potential, hence it is not advised for most investors.

Breakeven


If the option is sold for intrinsic value and assignment happens immediately, the investor breaks even.
The option will expire in that instance, and the short stock position will be closed out as well.
If the investor is allocated the same day, the cash obtained from the short sells will be paid out immediately, leaving no time for interest to accrue.
The assigned stock will be used to cover the short immediately.


Shorted stock price + premium received = breakeven.

Volatility


All other factors being equal, a rise in volatility would be detrimental to this strategy.

Time Passes


All other things being equal, the passage of time will have a favorable influence on this technique.

Assignment Danger


Yes.
Early exercise simply implies that no more interest is received from the method since assignment liquidates the investor's stake.


Also, be aware that if a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, usual expectations for early execution of options on the stock may be entirely thrown off.

Risk of Expiration


Yes.
However, there's a chance that late news prevents the option from being exercised, resulting in a big increase in the stock the following Monday.
A big rise in the stock price, not only near expiration, is always a threat to this approach.

Comments


This dangerous technique is not advised for most investors because to its limited profits, infinite risk potential, and the normal problems of selling stock short.
It's difficult to sell a deep-in-the-money put at its inherent value in practice.
This technique is provided more as a learning tool to better understand the impacts of cost of carry than as a viable option for the average investor.