What are the characteristics of this option strategy?
Poor man’s covered put trades buy a deep-in-the-money put of distant expiration and write an out-of-the-money put of near expiry against it, a long put diagonal spread. The structure expresses a bearish view on the stock without shorting the shares, and generates income from the premium collected on the option sold. The long put stands in for the short stock position at a fraction of the margin, and it also sets the maximum loss: the net debit paid to open the spread.
Is this a bullish, bearish or neutral strategy?
The Poor Man’s Covered Put Option Strategy is typically a bearish strategy. It is used when a trader has an opinion on the downside direction of the underlying asset. It profits if the underlying falls toward the short strike, and the premium from the short put offsets part of the loss if the stock rises instead. That premium reduces the loss, it does not prevent it, and a rally above the long strike still costs the whole debit paid.
Is this a beginner or an advanced option strategy?
This is an intermediate to advanced option strategy. It is a diagonal spread, with two strikes and two expirations to manage, and the trader has to handle early assignment on the short put, roll that leg as it expires, and judge what the long put is worth at the time.
In what situation will I use this strategy?
The Poor Man’s Covered Put Option Strategy should be used when expecting the underlying asset to make a slight downside move rather than a large directional move. This could be due to a lack of a one-direction downside move of the asset or when you prefer to take profits sooner rather than later.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
This is a defined-risk, moderate-reward trade with a moderate probability of profit. The loss is capped because the long put is bought outright rather than sold, so the worst case is the net debit paid, $2,838 in the example below. Defined does not mean small, and that debit is most of the capital committed. The reward is capped in turn by the short put, which gives back every dollar the long put makes below its strike while it is open.
How is this strategy affected by the Greeks?
The Greeks, or delta, gamma, theta, vega, and rho, are the main factors that can affect the profitability of any option strategy. This strategy is affected by the theta and vega Greeks, which measure the option’s time decay and volatility, respectively. The position is net long vega, because the long-dated $300 put carries more vega than the short-dated $250 put, so rising implied volatility helps it. Time decay works in your favour only while the stock stays above the short put's strike, where the short leg decays faster than the long one.
In what volatility regime (i.e., VIX level) would this strategy be optimal?
Entering when the VIX and implied volatility are low keeps the cost of the long-dated put down, which is the larger of the two legs and the one that sets the debit. Because the position is net long vega, a rise in implied volatility after entry helps it rather than hurting it, which is the opposite of a naked premium-selling trade. What does not help is buying the long put into an already elevated volatility regime and then watching that volatility fall.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
Adjusting this strategy when the trade goes against you can be quite difficult. If the stock rallies hard, both legs lose value together and there is little that repairs the position beyond closing it. The most common adjustments are to buy back the short put and rewrite it at a lower strike or a later date to collect more premium against the long put, or to close the spread outright. The one comfort is that the loss cannot exceed the debit already paid, so waiting is a choice rather than an obligation.
Where does this strategy typically fall in the range of commissions and fees?
This is a two-leg trade, and the short put is usually rolled every month, so the commissions add up faster than they would on a single position held outright. What it saves is margin rather than fees: the long put is paid for once, whereas a short stock position of the same size has to be margined for as long as it is held.
Is this a good option income strategy?
It can be, because the short put can be rewritten while the long put is held, and the loss is capped at the debit paid rather than being open-ended. That limit is the whole debit, though, so a stock that rallies and stays up loses the position outright even after several rounds of collected premium.
How do I know when to exit this strategy?
The investor should exit the trade when it is no longer suitable for their risk tolerance or when the underlying security moves significantly against the position. The routine exits are the short put expiring worthless and being rewritten, buying it back once most of its premium has decayed, or closing both legs together once the stock has fallen to the short strike and little is left to gain.
How will market makers respond to this trade being opened?
Market makers typically do not have an opinion on this type of trade. They will quote each leg and hedge the resulting delta. Note that the short put here is not uncovered: the long-dated put behind it is what defines the risk and what the broker recognises as the cover.
What is an example (with calculations) of this strategy?
For example, suppose a trader wants to execute the Poor Man’s Covered Put Option Strategy on company MSFT trading at $272. In that case, they will first buy an in-the-money put option of MSFT with a strike price of $300 having an expiration date of 90 days at the market price of $30 and then sell one put option with a strike price of $250 expiring one month from now for a premium of $1.62 per share. The long put costs $3,000 and the short put collects $162, so the net debit is $28.38 per share, or $2,838 per contract.
The maximum loss is that $2,838, taken if MSFT is above $300 when the long put expires and both legs finish worthless. Measured at the long put’s expiry with the short put already gone, the position breaks even at $271.62, the $300 strike less the $28.38 net debit per share. The maximum profit, if both legs were carried to the same expiry, is the $50 distance between the strikes less the $28.38 debit, or about $21.62 per share, $2,162 per contract, with MSFT at or below $250. Because the short put actually expires 60 days before the long one, the trader is still holding a put with time value at that point, so closing there normally returns more than the $2,162 floor. Below $250, though, the short put loses a dollar for every dollar the long put gains while it is open, which is what caps the trade.
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