Covered Straddle Explained

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Covered Straddle

What Is a Covered Straddle?

A covered straddle is an option strategy that seeks to profit from bullish price movements by writing puts and calls on a stock that is also owned by the investor. In a covered straddle the investor is short on an equal number of both call and put options which have the same strike price and expiration.

How Covered Straddles Work

A covered straddle is a strategy that can be used to potentially profit for bullish price expectations on an underlying security. Covered straddles can typically be easily constructed on stocks trading with high volume. A covered straddle also involves standard call and put options which trade on public market exchanges and works by selling a call and a put in the same strike while owning the underlying asset. In effect it is a short straddle while long the underlying.

Similar to a covered call, where an investor sells upside calls while owning the underlying asset, in the covered straddle the investor will simultaneously sell an equal number of puts at the same strike. The covered straddle, since it has a short put, however, is not fully covered and can lose significant money if the price of the underlying asset drops significantly.

Key Takeaways

  • A covered straddle is an options strategy involving a short straddle (selling a call and put in the same strike) while owning the underlying asset.
  • Similar to a covered call, the covered straddle is intended by investors who believe the underlying price will not move very much before expiration.
  • The covered straddle strategy is not a fully “covered” one, since only the call option position is covered.

Example of Covered Straddle Construction

As in any covered strategy, the covered straddle strategy involves the ownership of an underlying security for which options are being traded. In this case, the strategy is only partially covered.

Since most option contracts trade in 100 share lots, the investor typically needs to have at least 100 shares of the underlying to begin this strategy. In some cases, they may already own the shares. If the shares are not owned the investor buys them in the open market. Investors could have 200 shares for a fully covered strategy, but it is not expected that both contracts be in the money at the same time.

Step one: Own 100 shares with an at the money value of $100 per share.

To construct the straddle the investor writes both calls and puts with at the money strike prices and the same expiration. This strategy will have a net credit since it involves two initial short sales.

Step two: Sell XYZ 100 call at $3.25 Sell XYZ 100 put at $3.15

The net credit is $6.40. If the stock makes no move, then the credit will be $6.40. For every $1 gain from the strike the call position has a -$1 loss and the put position gains $1 which equals $0. Thus, the strategy has a maximum profit of $6.40.

This position has high risk of loss if the stock price falls. For every $1 decrease, the put position and call position each have a loss of $1 for a total loss of $2. Thus, the strategy begins to have a net loss when the price reaches $100 – ($6.40/2) = $96.80.

Covered Straddle Considerations

The covered straddle strategy is not a fully “covered” one, since only the call option position is covered. The short put position is “naked”, or uncovered, which means that if assigned, it would require the option writer to buy the stock at the strike price in order to complete the transaction. However, it is not likely that both positions would be assigned.

While gains with the covered straddle strategy are limited, large losses can result if the underlying stock tumbles to levels well below the strike price at option expiration. If the stock does not move much between the date that the positions are entered and expiration, the investor collects the premiums and realizes a small gain.

Institutional and retail investors can construct covered call strategies to seek out potential profits from option contracts. Any investor seeking to trade in derivatives will need to have the necessary permissions through a margin trading, options platform.

Covered Straddle Explained

The covered straddle is a perfect strategy for those all too common sideways-moving trends. When a company’s stock is in consolidation, how can you make trades? No directional trend exists, so most traders simply wait out this period.

The problem is that many stocks spend more time in consolidation than in either bullish or bearish trends. At these times, a strategy designed to generate cash with minimal market risk would be ideal. This is where the covered straddle is valuable.

Short straddles are associated with high exercise risk because both sides are short. This means that the likelihood of one side being in the money is just about unavoidable. For this reason, many traders avoid short straddles, and for good reason. The risk is obvious: Premium income must be greater than the loss upon exercise, and this often is so marginal that net losses can and do occur.

The whole situation changes drastically when the short call is covered. The covered straddle consists of owning 100 shares, writing one covered call, and writing one uncovered put. The market risk of the uncovered put is the same as the market risk of the covered call. As a result, market risk on both sides is drastically reduced simply by converting a naked call to a covered call.

This doesn’t mean losses cannot occur. If the stock declines suddenly, well below the level of net premium received, the loss will result. As a result, traders should be prudent about which stock they choose for covered straddles and should be willing to close out positions once one side or the other becomes profitable. The most likely timing for a successful covered straddle is when the stock is range-bound and in consolidation.

Keeping on eye on price moving toward breakout from consolidation is a smart way to avoid unpleasant surprises. All trends end, including consolidation. Being aware of the potential for breakout, and especially for a sudden and rapid breakout, requires diligence and the need to act quickly. The plan for a covered straddle is to exploit time decay, and profits can be taken as long as the price remains within the existing boundaries of the trading range.

With this tactic in mind, it makes sense to open covered straddles that expire within one to two weeks. Premium income would be greater for longer-term expirations, but that also means accepting much greater risks. In most cases, you will see more profits from time decay in a series of one-week and two-week covered straddles, than from longer-term positions.

The covered straddle, like the more traditional short straddle without cover, consists of equal numbers of calls and puts, opened with the same strike and expiration. However, by also owning 100 shares for each set of contracts, the call side’s risk is drastically reduced. Because the market risk of each side is identical, a covered straddle contains the same market risk as writing two covered calls. The difference is that you do not need to double the number of shares held at the time the position is opened.

Maximum profit will take place at expiration when the underlying is trading at the strike. This will rarely happen so on practical basis, assume maximum profit will be equal to the underlying trading at or above the strike, adjusted by the underlying price and by net premium earned:

P = premium received

F = trading fees

Ub = basis in underlying

M = maximum profit

A breakeven point occurs at underlying price plus strike, minus net premium earned:

Ub = basis is underlying

P = premium received

F = trading fees

The problem with a covered straddle is that net losses are unlimited. Although the uncovered put has the same market risk as the covered call the underlying price could decline a good distance (but is not truly unlimited, because price will not decline beyond zero). Maximum loss is calculated as:

Ub = underlying basis price

Uc = underlying current price

Pc = put, current premium

Pb = put, net sale premium

M = maximum loss

This overall net loss has three components. First is the loss on stock; second is loss on the put; and third is an adjustment for the net premium earned. However, this worst case outcome is not always earned; in fact, it can be avoided in most instances. The stock loss is unrealized unless stock is disposed of at a net loss. The paper loss on the short put can be deferred or avoided by rolling forward to avoid the loss resulting from exercise.

In other words, the structure of this strategy enables you to exert control and to manage losses to minimize or avoid them altogether.

An example of the strategy:

  • 100 shares purchased @ $102, $10,200 plus trading fees = $10,209
  • Sell 105 call, bod 3.20, less trading fees = $311
  • Sell 105 put, bid 2.90, less trading fees = $281

Outcomes for this trade, assuming the stock price ends up at either $105 (at the top) or $92 (at the bottom) are:

  • Maximum profit: 5.92 + ( 105 – 103 ) = 8.92 ($892)
  • Breakeven: ( 102 + 105 – 5.92 ) ÷ 2 = 100.54 ($100.54)
  • Maximum loss: ( 102 – 92 ) + 10 – 2.81 ) = 17.19 ($1,719)

Actual outcomes rely, of course, on where the stock price ends up. The result above is summarized in the illustration below.

The worst case analysis is just that, the outcome if a trader does not act to close positions once stock price movement begins. Whether prices move up or down, one side or the other can be closed and profits taken. This advantage is maximized if the consolidation trend continues in effect.

The covered straddle is often overlooked with the point of view that options trades only work when a bullish or bearish trend is underway. This strategy is an exception, and it can lead to profits while you wait for a new dynamic trend to begin.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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    Covered Straddle

    Definition:
    A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

    For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

    For stock options, each contract covers 100 shares.

    Buying Put Options

    Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

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    A Simplified Example

    Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

    Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

    Let’s take a look at how we obtain this figure.

    If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

    This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

    Protective Puts

    Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

    Selling Put Options

    Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

    Covered Puts

    The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

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    The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

    For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

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    A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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