Introduction to Covered Straddles
The covered straddle strategy involves selling a call option and a put option at the same strike(exercise) price and expiration date for every 100 shares of the underlying asset purchased. The covered straddle is simple a covered call strategy with an additional naked put written. Hence the covered straddle is not fully “covered”. Typically the options of a covered straddle are at the money.
Writing a covered straddle will result in a net credit.
Read more : What does “net credit” mean in options trading?
Step 1 : Perform economic, fundamental and technical analysis
The trader should perform economic, fundamental and technical analysis. Some suggested chart patterns that the trader should look out for are(not meant to be exhaustive):Option straddle(Long straddle)
Read : Basic economic analysis
Step 2 : Outlook – Moderately Bullish
An options trader that uses a covered straddle is moderately bullish on the underlying security. The price of the underlying security should not trade outside a range.While being slightly bullish in the underlying security, the market volatility is also predicted to decline from current levels. As such, when an options trader writes a covered straddle, he is able to collect a maximum premium when volatility is high.
Step 3 :Study the option chain
Next, a trader should examine the options chain and select the options to be used in the covered straddle.
Step 4 : Breakeven Analysis
To calculate the breakeven point for writing a covered straddle, we can calculate it using the formula below.
(Acquisition Price underlying security + Strike Price of shorted put – premium collected from straddle) 2
Step 5: Understand Your Profit Zones
After the calculation of the breakeven point, the trader is able to understand where the profit zones is.
Step 6 : Potential for unlimited losses
When the stock price is greater than that of the strike(exercise) price of the shorted call, the investor makes a limited profit in a covered straddle. But if the stock price tanks and goes below the strike(exercise) price of the shorted put, the trader can make a huge loss. The trader makes a loss on both the shorted put and the underlying stock when that happens.
Step 7 : Loss calculation
When the price of the underlying security trades below the strike(exercise) price of the shorted put, a loss can occur.
The loss can be calculated as :
Loss in price of underlying security + loss on shorted puts – gain on shorted calls
This is contingent on the price of the underlying asset decreasing to an extent that it trades below the original acquisition price and the strike(exercise) price of the shorted call to warrant an overall loss on the trade.
Step 8 : Limited profit
The profit potential of a covered straddle is limited due to the shorted call. If the shorted call is in the money, it could be called away and the investor earns a limited profit. The maximum profit in a covered straddle occurs when the trading price of the underlying asset is greater or equal to the strike(exercise) price of the shorted call.
Step 9 : Profit calculation
Maximum profit = Strike price of the shorted call – trading price of the underlying asset + premiums collected from shorted options – commissions paid to the broker
Step 10 : Calculate Risk & Reward Ratio
It is wise to think about the trade in terms of risk and reward. For every dollar of risk that a trader is willing to take, how much reward could he possibly get. Of course, the risk and reward of one strategy will differ to that of another strategy. Hence, when comparing risk and reward ratio, compare for example, the risk reward ratio of writing a covered straddle for trade A versus writing a covered straddle for trade B.
Step 11 : Setting up the trade
- Buy 100 shares
- Sell 1 ATM call
- Sell 1 ATM put
Step 12 : Exit Trade & Record Trade In Diary
After the trade has been exited, record and detail the trade’s performance in a diary for reflection, review and analysis.
Example Of A Covered Stradle
PQR Corp is trading at a price of $42.50. An investor buys a 100 shares of PQR corp with $4250. He also writes a December 45 put and a December 45 call and receives $400 and $150 as premium respectively.
Effectively, he has purchased the stock at a lower price of :
$4250 – $400 – $150 = $3700
The premiums collected serve to reduce the cost of acquiring the asset.
However, profits are limited and capped.
If the price of PQR becomes $47 just before the expiry date of the options, the gain on the underlying asset is:
$4700 – $4250 = $450
The loss on the call is: ($47 – $45) x 100 – $150 = $50
The gain on the short put : $400 as it expires worthless.
Net gain = $450 – $50 + $400 = $800
Net gain = $4500 – $3700 = $800
But if the price of PQR trades at $35 just before the expiry date of the options, the loss on the underlying asset is:
$4250 – $3500 = $750
The loss on the short put is: ($45 – $35) x 100 – $400 = $600
Gain on short call is: $150
Net loss = $750 + $600 – $150 = $1200
A variation of the covered straddle but with greater risk
A modification of the covered straddle is the uncovered straddle or the short straddle. An uncovered straddle or a short straddle is essentially the writing of an equivalent number of puts and calls at the same strike(exercise) price derived from the underlying asset without the ownership of the underlying asset. In that sense, the uncovered straddle carries more risk than the covered straddle. In a covered straddle, when the price rises, the call option can be called away and the writer sells off his stock. But in an uncovered straddle, the trader has no ownership of shares and hence if the price rises, the potential losses are unlimited as the stock could rise theoretically to infinity.
Read next : Uncovered straddle/Short straddle/Sell straddle