Covered Short Strangle

 

Description

         

The Covered Short Strangle is another risky income strategy, though it is certainly an improvement on the Covered Short Straddle. The concept is to increase the yield of the Covered Call by selling an out-of-the-money (lower strike) put. In this way we take in the additional income from the sold put; however, if the stock price falls below the put strike, there is a significant price to pay in terms of risk.

 

The sold put adds significant extra risk to the trade. The amount of potential risk added is the put strike less the put premium received. Say if we trade a Covered Call on a $24.00 stock, taking in $1.00 for the $25 strike call, our risk and break even is $23.00. If we sold a $22.50 strike put for another $1.00, our initial yield on cash would be doubled. . . but our risk would have increased by another $21.50 ($22.50 minus $1.00), making our total risk $44.50 if the stock falls to zero.

 

Although this is unlikely to occur in just one month, the position can become loss-making at approximately double the speed as a simple Covered Call position, so if the stock starts to fall, we can be in trouble much more quickly.

 

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 will 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 are happy because our sold put expires worthless, our sold call is exercised, and we simply deliver the stock we already own.

 

P/L Profile

 

   

   

 

 

When To Use

 

If you have enough cash to fulfill the exercise you may have on the downside, and you are confidently bullish and want to accrue income.

 

Example

 

XXXX is trading at $28.20 on February 25, 2011.

Buy XXXX at $28.20.

Sell the March 2011 30 strike put for $2.60.

Sell the March 2011 30 strike call for $0.90

 

Benefit

 

The ability to increase the yield of a covered call.

 

Risk vs. Reward

 

The risk is that if the stock falls, the calls will expire worthless and you will have to buy more stock. However, the reward, if the strategy is executed well, is increased yield.

 

Net Upside

 

Premium received for the calls and puts plus the strike price minus the purchase price of the stock.

 

Net Downside

 

The purchase price of the stock plus strike price minus put premium minus call premium.

 

Break Even Point

 

The break even would be the strike price minus half the premium income received plus half the difference between the strike price and the stock price.

 

Effect Of Volatility

 

N/A

 

Effect Of Time Decay

 

Positive. Time decay erodes the value of the sold options.

 

Alternatives Before Expiration

 

Facing a loss, sell the stock or sell the stock and buy back the call sold. If the put is exercised, you will have to buy the stock at the put strike price.

 

Alternatives After Expiration

 

If the stock falls under the put strike price, exercise will take place and you will have to buy more stock at the put exercise price. The calls sold will expire worthless. You keep the premium.

 

Close out the position if the shares rise above the call strike price, and take the profit.