Let’s create an example of a covered put strategy using Eastman Kodak Co. (EK) by going short 100 shares of EK @ 74 and short 1 January EK 70 put @ 4. For this position to keep the credit, the stock’s market price needs to stay above $70. The maximum profit for this trade is the premium received for the short put option plus the money accrued from the sale of the stocks if the option is exercised. The maximum reward on the option side of this position is $400 [(4 x 100 = $400). The maximum reward on the side of the stocks of this position is $400 [(74 – 70) x 100 = $400]. This creates a total profit of $800 (400 + 400 = $800). The maximum risk is unlimited to the upside beyond the breakeven. This trade requires a margin deposit to place. The table above shows the risk profile for this trade.
The breakeven on covered puts is calculated by adding the put options’ premiums to the price of the underlying stocks at initiation. In this example, the breakeven is 78 (74 + 4 = 78). Unfortunately, placing a covered put will not protect you from sharp rise above the breakeven. If Eastman Kodak rises above 78, the trade will start to lose money. However, selling a put against a short stock does increase the breakeven. If you were to simply the sell the stock, the breakeven would be the purchase price of the stock at initiation or 74. If Eastman Kodak falls below the strike price of the put, there is a possibility that the put will be assigned and you will be obligated to purchase the stock at the strike price. If so, you can return those shares to your brokerage to cover the short shares at the higher initial price and pocket the difference as profit.
By tracking this trade, we find that Eastman Kodak actually rose above the breakeven 2 days before expiration, only to plummet to 69 on expiration day. There is a good chance that the put received Notice of assignment at which time the short stock position was closed out for a total profit on the trade of $800. Since Eastman Kodak continued in a bearish trend after the option expired, we potentially missed a bigger profit on the stock by having to use the shares to fulfill our obligations on the assigned short put. Such is life.