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This strategy is opposite to a Covered Call strategy. A Covered Call is a neutral to bullish strategy, whereas a Covered Put is a neutral to Bearish strategy. As an investor, you follow this strategy when you the price of a stock/index is going to remain range bound or move down. Covered Put writing involves a short in a stock/index along with a short Put on the options on the stock/index.
The Put that is sold is generally an OTM Put. The investor shorts a stock because he is bearish about it, but does not mind buying it back once the price reaches (falls to) a target price. This target price is the price at which the investor shorts the Put (Put strike price). Selling a Put means, buying the stock at the strike price if exercised (Strategy No. 2). If the stock falls below the Put strike, the investor will be exercised and will have to buy the stock at the strike price which is anyway his target price to repurchase the stock at the strike price—which is anyway hi target price to repurchase the stock.
The investor makes a profit because he has shorted the stock and purchasing it at the strike price simply closes the short stock position at a profit. And the investor keeps the Premium on the Put sold. The investor is covered here because he shorted the stock in the first place. If the stock price does not change, the investor gets to keep the Premium. He can use this strategy as an income in a neutral market.
When to use: If the investor is of the view that the markets are moderately bearish.
Risk: Unlimited if the price of the stock rises substantially.
Reward: Maximum is (Sale Price of the Stock—Strike Price) + Put Premium
Breakeven: Sale Price of Stock + Put Premium
Suppose ABC Ltd. is trading at Rs. 4500 in June. An investor, Mr. A, shorts Rs. 4300 Put by selling a July Put for Rs. 24 while shorting an ABC Ltd. stock. The net credit received by Mr. A is Rs. 4500 + Rs. 24 = Rs. 4524.
Strategy: Short Stock+Short Put Option