The Regret Point

Since the goal of a covered put is to either pocket the premium received or to buy the stock at a discount to its current price by getting paid while waiting to see if we get our buy order filled, is there a situation when that waiting is a mistake? Is there an outcome where simply buying the stock would have been better than trying to pocket the premium? Since the profit from a short put is capped at the premium received, the answer is yes. If the stock rallies, then it's possible that the profit foregone from not buying the stock is greater than the premium received and kept. The point at which the profit from simply buying the stock is equal to the premium that would be received is the regret point. Above this level, the put seller will regret not simply buying the stock because the profit missed from not buying the stock is greater than the premium received.

Careful readers will recognize the term regret point from our discussion of selling a covered call in Chapter 4. That's because selling a covered call, particularly if buying the stock and selling the call at the same time, is very similar to selling a cash covered put. We'll discuss this similarity later in this chapter.

Market Outlook

The appropriate market outlook for a covered put is generally slightly bullish, slightly bearish, or neutral. In any of those outcomes, the covered put seller will keep the entirety of the premium received, and, in general, few strategies would have been superior. Usually, if a trader were very bullish, they would execute a different strategy, since a covered put can only make the original premium collected no matter how high the underlying stock goes. If a trader is very bearish, then he might buy a put rather than selling a covered put, but selling a covered put will be profitable if the stock drops only slightly yet remains above the breakeven point. A covered put will realize its maximum potential profit, the full amount of the premium received, if the underlying stock does anything, including dropping, but is above the strike price at the time of option expiration. If a trader believes the underlying stock will move sideways, that is will neither rally significantly nor drop significantly, then a covered put would be a very logical choice.

Notice that all three market outlooks that are appropriate for a covered put (up slightly, down slightly, or sideways) need the underlying stock to be rather docile or not volatile. That's because selling a covered put is a short volatility strategy, it does best with low realized volatility from the time the option is sold until expiration.

But it's possible to construct a covered put that can make money even if the stock drops substantially (by selling a deep out-of-the-money put), and it's possible to construct a covered put that makes money without reaching the regret point even if the stock rallies substantially (by selling an in-the-money put). In fact, by selling an in-the-money put the market has to rally in order for the position to achieve its maximum profit. Let's look at all three strategies because they're different and assume different market outlooks.

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