Trading Strategies (Options) – 2
As promised in earlier post (Trading Strategies (Options) – 1), today I am writing about COVERED SHORT PUT strategy.
What is Covered Short Put?
A covered short put position is constructed by selling a put but, at the same time, holding sufficient funds to buy the asset if necessary or already having a short position, such as being short the futures contract then writing/selling a put on the futures contract.
Example
XYZ plc share price is 207. An investor leaves the funds (2070) on deposit and sells the 200 put for 20 per share.
Let us now analyze the outcome at expiry.
1) If the share is price is unchanged at expiry, the option is abandoned by the long and the investor keeps the premium. This increases the return on his funds by the premium retained.
2) If the share price rises, although the investor is enhancing the return on this funds by the premium received, he has forgone the opportunity to make a profit on the shares he could have purchased. There is an opportunity cost for the investor.
3) If the share price falls below 200, the option will be exercised against the investor. He will have to buy the shares at 200. The investor has effectively reduced the cost price of the shares to 200, less the amount of the premium. That is 180 (200 – 20).
The investor makes maximum profit when the share price is unchanged (that is at 200). The investor will make 20 on the premium, plus interest on the funds, and be able to buy the shares at 200 rather than 207.
Summary
The motivation of this strategy is to enhance the return on funds in a stagnant market and to partially hedge a short underlying position. It is also an attractive method of taking profit on a short position.
Rish/Reward Summary
- Loss : Unlimited once the underlying asset (stock or futures contract) price falls below the break-even-point.
- Maximum Profit : Limited to premium received (if the option expired unexercised).
In my next post I shall discuss Options spreads
