This strategy is applied when you have a bearish outlook on the market. The potential loss is unlimited if the market moves upwards.
Let’s understand it better with a live Nifty futures option combination.
Today on Jan 16th 2017 Nifty has been closed at 8412 after a very narrow range of trying with 20 – 30 points on either side. You are expecting Nifty to go down in the coming days. So you initiate a covered put strategy by
- Sell 1 lot January futures
- Sell 1 lot Jan 8400 PE at 45
Now let’s consider the following three scenarios at the time of expiry.
- Nifty has gone down 200 points and closed at 8200.
- You will earn 212 points in futures since you have shorted it.
- Same time you will loose 200 points in option since you have written it.
- Your net profit will be net premium received by writing the put option. It will come to 45 x 75 = Rs. 3375.
- Nifty stayed at the same level , let’s say 8410 at the time of expiry.
- You will loose a marginal 2 poin in futures.
- 8400 PE will expire worthless and you will keep the premium collected by selling it.
- Your total profit on this situation will be ( 45 -2 ) x 75 = Rs. 3225.
- Nifty rallies another 200 points and closes at 8600.
- You loss in futures would be 178 points.
- 8400 put will expire worthless and will contribute 45 points relief to your total loss.
- You net loss in the above situation will be ( 178 – 45 ) x 75 = Rs. 9975.
As we see the results from various conditions, it is very clear that the strategy acts like a naked call writing and the maximum loss potential is unlimited. Though it not a popular strategy, it worth knowing it.
Covered put can be used to generate a limited income in a neutral to bearish market. You will incur unlimited loss if the market rallies away. You will have a maximum relief of the total premium collected by selling put options. Over and above that any movement will contribute to your losses. There are many strategies which limits your risks. Read our other strategies and select suitable one for your trading style.
Hope this article helped you in learning another option strategy. Happy reading …