Introduction To Covered Strangle Options Strategy
A covered strangle strategy involves the purchase or ownership of the underlying security while selling out of the money puts and calls on the same underlying security with the same strike(exercise) price and expiration date. As a result, the trader receives premiums from 2 sides, the calls and the puts. The advantage is obvious – A greater premium is collected as compared to the covered call writing strategy.
Steps
Step 1: Perform economic, fundamental and technical analysis
Step 2: Outlook: Moderately Bullish
Step 3: Study the option chain
Step 4: Perform Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6: Potential for unlimited loss
Step 7: Loss calculation
Step 8: Limited potential profit
Step 9: Calculation of profit for a covered strangle
Step 10: Calculate Risk & Reward Ratio
Step 11: Set Up Trade: Executing the covered strangle strategy
Step 12: Exit Trade
Step 13: Record Trade In Diary
Step 1: Perform economic, fundamental and technical analysis
The whole idea about performing economic, fundamental and technical research is to make sure that the general direction of the underlying security is up. While markets and financial securities can be unpredictable, this step will give a trader the confidence to execute a covered strangle. Some suggested chart patterns that the options trader should look out for is:
Read: Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2: Outlook: Moderately Bullish
The options trader should now be moderately bullish on the underlying security. This is ideal for executing a covered strangle.
Step 3: Study the option chain
Next, he should study the option chain. There is an interplay of the strike price, price of underlying security and option premium. By selecting the option contracts to construct the covered strangle, the options trader is able to move on to the next step, that is, perform breakeven analysis.
Read: Learn to read and understand options chain
Step 4: Perform Breakeven Analysis
The breakeven price point can be calculated as per the formula below.
Breakeven price point = (Strike price of short put + acquired price of underlying security – Premium collected from sale of options) x ½
This breakeven point will allow the trader to understand his profit zone.
Step 5: Understand Your Profit Zones
The profit zone is marked by the breakeven point which has been calculated in Step 4. Ideally, the price of the underlying security should trade within the profit zone.
Step 6: Potential for unlimited loss
When the price of the underlying security makes a break to the downside, the potential for losses is unlimited. That is because not only does the investor suffer a loss in value on the underlying security, the investor may also be forced to close his written put at a loss. The greater the price of the underlying security below the breakeven point, the greater the losses.
Step 7: Loss calculation
Loss = strike(exercise) price of short put + Acquired price of the underlying security – maximum profit – (price of underlying security x 2) + Commission paid to broker
For calculation of maximum profit, do look at the formula below in Step 9.
Step 8: Limited potential profit
Understand that the profit potential of a covered strangle strategy is limited. A profit is realisable if the price of the underlying security is greater than the strike(exercise) price of the shorted call. When that happens, the long stock position gets called away as the investor has the obligation to sell his stock at the strike(exercise) price of the call when the call is in the money. That results in a profit as the investor actually purchased the shares at a lower price than the strike(exercise) of the call. The investor also gets to keep the premium collected when writing both the call and put options.
Step 9: Calculation of profit for a covered strangle
A profit is realisable when the price of the underlying security is greater than the strike price of the call. However, that profit is limited. The maximum profit is calculated as:
strike(exercise) price of call – acquired price of the underlying security + premiums collected from shorting options – Commissions paid to the broker
Step 10: Calculate Risk & Reward Ratio
After the steps above, the trader should calculate his risk and reward ratio. If the reward is not worth the risk relative to other trades he can make or the past trades he has made, the trader should reconsider using a covered strangle. The risk and reward ratio can also be calculated based on the necessary stop losses in place.
Read more: Understanding Risk/Reward Ratio For Option Traders
Step 11: Set Up Trade: Executing the covered strangle strategy
- Long 100 shares
- Short 1 OTM put option
- Short 1 OTM call option
Step 12: Exit Trade
If the trade is profitable, the trader should consider closing the trade especially if the maximum profit is realisable at that point in time. With the covered strangle, assignment is a possibility.
Step 13: Record Trade In Diary
After the trade has been exited, calculate actual profit or loss realised. Record this and more in the trading diary. Examine the trade again and figure out if anything can be done better.
Example of a covered strangle strategy
QWE Corp is trading at a price of $42.50. An investor decides to do a covered strangle by buying 100 shares of QWE at a price of $42.50 and simultaneously writing a December 45 call and a December 40 put. The premium received from the put is $100 and the premium received from the call is $100.
The breakeven price point is:
(40 + $42.50 – 2) x ½ = $40.25
If the trading price of QWE falls below $40.25, the investor makes a loss.
Let us consider a scenario where the trading price of QWE is $35 on the expiration date of the options. The loss on the stock position is:
($42.50 – $35) x 100 = $750
The loss on the put is :
($5 – $1) x 100 = $400
The put option is in the money by $5 on expiration date.
Total loss = $400 + $750 – $100 = $1050
The investor gets to keep the premium of the short call of $100.
As you can see, when the trading price of QWE falls below the breakeven price point, the investor with a covered strangle strategy makes a loss.
Now, let us consider a scenario where the price of QWE is trading at $48 on the expiration date of the options.
The gain on the stock position is:
($45 – $42.50) x 100 = $250
The investor gets to keep the premium of the short put.
Hence, the total profit is:
$250 + $100 + $100 = $450
Comparable Strategies
The covered call strategy is comparable to the covered strangle strategy in a sense that both have similar payoff profiles. The difference is that in a covered strangle, the breakeven point is lower due to more premiums being collected by the trader.
Read: General Overview Of Covered Calls
Execute An In the Money Covered Call