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A covered strangle is a neutral strategy that’s traded when little volatility is expected before options expiry. The trade is no different from a standard short strangle, save for the fact that the position is covered. Should the underlying trade higher and the call option be assigned, the trader already holds the stock necessary to sell to the call buyer.
On the other hand, should the underlying drop below the put strike, the trader has (or should have) sufficient cash on hand to purchase more stock at a reduced price.
The trade is an unlimited risk/limited reward proposition.
Composition
The covered strangle is composed of:
- One short out-of-the-money call
- One short out-of-the-money put,
- 100 shares of the underlying security
- Sufficient cash to buy the stock at the put strike
Traders employing the strategy consider the underlying to be fully valued, and are therefore willing to part with their shares should they rise in price or buy more should they fall.
Let’s look now at a trading example to better appreciate the strategy’s ins and outs.
This is a chart of agricultural giant Archer Daniels Midland Co. (NYSE: ADM) for a period of six months:
In mid-February, with ADM shares stuck in a range and projected to do so for some time to come, you consider new ways to make money off the board lot that’s been sitting in your portfolio for years. A 2% dividend is nice, but you want to generate something more substantial if you can.
All your research suggests the stock is fairly priced, and because options premiums are reasonably rich, you consider selling a straddle. Should the stock gain some ground, you figure it won’t be for long, so there’s no harm done if they get called away. Conversely, you wouldn’t mind owning a little more if the price pulled back somewhat.
With that in mind, you step up to the plate. It’s early February, the shares are trading at $48, and you sell one May 50 call and one May 46 put, each for $2.50. You pocket your premium and wait.
Drifting Into Spring
ADM moves ever so slightly higher and lower for the next 10 weeks, and for only two trading days in early March are your options ever in the money. You don’t worry, though, because your initial $5 premium puts your downside break-even level at $41 (put strike less premium collected [$46 – $5]), and the stock only ventures as low as $45.20.
By the time expiry rolls around, the stock has levitated to close at $52.50. The short call is in the money, and your shares are called away at $50.
Your profit looks like this:
Your shares climbed from $48 to $50, offering you a $200 gain, while your initial credit of $500 also remains yours. Total profit is $700 on the trade, the maximum possible.
Losses and Gains
Maximum loss on the trade is theoretically unlimited should the stock drop to zero and your current shares (and newly assigned ones) become worthless. Officially, maximum loss is calculated like this: stock purchase price + put strike – net premium received.
Maximum gain is limited to: call strike – stock purchase price + net premium received.
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