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A reverse covered strangle is a neutral strategy employed by traders who are already short a stock they suspect has neared its bottom. Traders implementing the strategy are betting on little volatility before expiration and have a slightly bearish bent.
The trade is composed of a short sale of 100 shares of the underlying security, one short out-of-the-money call and one short out-of-the-money put.
2 Directions
Should the underlying fall below the short put strike, the option, of course, would be assigned, forcing the trader to buy in and thereby closing out his short for additional profit.
Should the stock trade higher, however, the trader risks having the call assigned, at which point he would be obligated to sell an additional lot of the underlying and be prepared to face larger losses if the stock kept trending higher.
Initiating such a trade implies that the trader is willing to take that risk. His bias is bearish, so taking on a bigger short position at a higher price is not a frightful proposition for him.
Let’s look at a chart of rail giant CSX Corp. (NASDAQ: CSX) to get a handle on the strategy’s finer points.
As you shorted CSX in the mid-$30s, you’re in a comfortable profit position, but of late the shares have been drifiting sideways. You’re fairly sure there’s little left to wring from the trade, but you’re open to a downside surprise. In the meantime, your broker suggests a strategy that will put some money in your pocket and reward you if the stock, indeed, continues lower.
It’s a reverse covered strangle, and in early September, with the stock trading at $28, you decide to get it on.
You sell one December $31 call and one December $25 put, each for $2.50, for a net credit of $500.
Break-Even and Profit/Loss Calculations
Should the stock reverse higher, you’re covered until $36 (call strike + premium received [31 + 5]), at which point the newly shorted shares (from the call assignment) would begin taking on water. Should they continue to rise beyond that level, losses would be theoretically unlimited.
As to the trade’s maximum gain, it’s calculated as follows: stock purchase price – put strike + net premium received.
As it turned out, in the above example things worked out swimmingly. The stock continued on its merry sideways meander for the next three months, after which it began to decline, closing at $25.55 by expiry.
Both options expire worthless, and you find yourself up $5.00 on the sale of the options and another $2.45 on the short sale, which you immediately close, for a net gain of $745.
Trading Note: Again, the trade is best applied by a trader who’s indifferent to either the call or put being assigned. If the put is assigned, the short is closed; if the call is assigned, he simply adds to his short position and awaits a further decline.
You won’t find this anywhere else
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