covered short strangle

Covered Short Strangle

Table of Contents

Basics Concepts – Covered Short Strangle

Covered Short Strangle

Description - Covered Short Strangle

  • The Covered Short Strangle is another risky income strategy, though it is certainly an improvement on the Covered Short Straddle.
  • If the stock falls below the put strike at expiration , the call will expire worthless (so we keep the premium), the put will be exercised , and we’ll have to buy more stock at the put strike price.
  • With a falling stock , this can be pricey and undesirable.
  • If the stock is above the call strike at expiration, then we’re happy because our sold put expires worthless, our sold call is exercised , and we simply deliver the stock we already own.
Description Covered Short Strangle

Introduction - Covered Short Strangle

Outlook

  • With covered short strangles, your outlook is bullish. You expect a steady rise.

Net Position

  • This is a net debit transaction because you are paying for the stock and only taking in small premiums for the sold put and call options.
  • Your maximum risk is the price you pay for the stock, plus the put strike price, less the premiums you receive for the sold call and put. This is a high-risk strategy

Effect of Time Decay

  • Time decay is helpful to your trade here because it will erode the value of the options you sold.

Time Period to Trade

  • Sell the options on a monthly basis.

Breakeven = Varies depending on the relationship between the stock price, premiums received, and the strikes

Steps to Trading a Covered Short Strangle

Steps In

  • Try to ensure that the trend is upward or range bound and identify a clear area of support.

Steps Out

  • Manage your position according to the rules defined in your Trading Plan
  • If the stock closes above the strike at expiration, your call will be exercised.
  • If the stock falls below the put strike, your put will be exercised, forcing you to buy more shares at the put strike price. This could become expensive.
  • If the stock is resting between the strike prices at expiration, then you’ll keep the premiums, but this is a dangerous strategy.

Exiting the trade - Covered Short Strangle

Exiting the Position

  • If the share rises above the (call) strike price, you will be exercised at expiration (or before) and therefore make a profit.
  • If the share falls below the (put) strike price, you will be exercised at expiration (or before) and will have to buy more stock at the put exercise price. Your sold calls will expire worthless, and you will keep the premium.
  • If the share stays between the strike prices, you will have successfully reduced your cost of entry because the premiums you took in will offset the price you paid for the stock.

Mitigating a Loss

  • Either sell the share or sell the share and buy back the call option you sold. If the put is exercised, then you
    will be required to buy the stock at the put strike price.
  • Please note that covered short strangles are risky, and you should ensure that you have enough cash in
    your account to fulfill the exercise obligations you may have on the downside.

Advantages and Disadvantages

Advantages

  • Generate monthly income.
  • Greater income potential than a Covered Call.
  • Less risky than a Covered Short Straddle.

Disadvantages

  • Very risky if the stock falls.
  • Expensive strategy in terms of cash outlay.
  • Capped upside if the stock rises.
  • Uncapped downside potential.
  • This is not a recommended strategy.