Covered Short Straddle
A Covered Short Straddle is an options strategy that combines risk management with the potential for profit from a stable market. It involves selling a call and a put option with the same strike price and expiration date, while owning the underlying stock in sufficient quantity to cover the call option. This strategy is used when the trader anticipating low volatility feels that the stock price would remain closer to the strike price.
The Covered Short Straddle Setup
For instance, imagine you have 100 shares of XYZ Corp trading at $100 per share. You look at selling a call and a put with a strike price of $100 and receive a premium of $5 for both of them. Both the options are set to expire on the same date.
Who Should Consider It
This strategy is ideal for investors who already hold the underlying stock and are seeking to generate extra income from their holdings through the premiums received from selling the options. It is best suited for those who expect the stock price to remain stable and are comfortable with the risks of potentially having to sell their shares or buy more.
Strategy Explained
When holding the stock and selling a call, it obligates you to sell your shares at the strike price in case the call is exercised. When selling a put, it obligates you to buy shares at the strike price in case the put is exercised. The covered part is derived from owning the stock, which covers the risk of the short call part of the straddle.
Feasibility Breakeven Process
There are two breakeven points for this strategy:
- Upper breakeven: Strike price + total premiums received.
- Lower breakeven: Strike price - total premiums received.
Applying the example above, the breakeven points would be:
- Upper breakeven: $100 + $10 = $110
- Lower breakeven: $100 - $10 = $90
Sweet Spot
In this case, the ideal buy/sell happens when the stock price ends up exactly at the strike price on the expiration date ($100 in this example), so he can collect the premium from both the call and the put.
Max Profit Potential
The maximum profit is capped at the sum of premiums received from both the options combined with any profit realized when selling the stock at the strike price if that is higher than the purchase price of the stock.
Max Loss
The maximum loss is more managed than an uncovered short straddle. If the stock price drops dramatically, losses on the stock position rise, but this is somewhat offset by the profits from the put option premium. The risk on the upside is limited since the stock covers the call.
Risk
The primary risk is that the stock moves considerably away from the strike price. In any case, because the shares cover the call, the risk is essentially on the downside; there’s a significant risk that a severe fall in the stock price may incur a large loss even as premium is received.
Time Decay
Time decay (theta) works in favor of this strategy. As expiration approaches, the value of the options decreases, which is beneficial when you have sold the options.
Implied Volatility
Low implied volatility at the time of strategy setup is beneficial because it reduces the cost of closing the position if needed. An increase in implied volatility could increase the options’ value, thus posing a risk.
Conclusion
A Covered Short Straddle allows a stockholder to capture income by buying the premium but will protect him from stock price movement on the downside. It is a prudent strategy for the investor who feels that his or her stock price should not fall but would like to hedge against moderate stock price movements. The investor should expect stock to be assigned on either side of the strike prices and have a plan in either direction.