This strategy is opposite to a Covered Call. A Covered Call is a neutral to bullish strategy, whereas a Covered Put is a neutral to Bearish strategy. You execute this strategy when you feel the price of a stock/index is going to remain within a range-bound or move down. Covered Put writing involves shorting a stock/index along with a short Put on the stock/index.
The Put that is sold is generally an OTM Put (OTM - Out Of The Money i.e when the Put Option's strike price is lower than the prevailing market price of the underlying stock).
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. At, this target price the investor shorts the Put (Put strike price).
Short or 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 Put will be exercised and the investor will have to buy the stock at the strike price (which is any way his 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. Let us understand this with an example.
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: The sale price of stock + Put [remium