Covered Short Strangle

The Covered Short Strangle Setup

Suppose XYZ Corp is trading at $50 a share. You already own 100 shares of it and wish to enter a covered short strangle by shorting a $55 strike call for $2 and a $45 strike put for $2, both of which expire in three months. The total premium you receive is $4.

Who Should Consider It

It is for investors who already own the underlying stock and anticipate it to trade within a range. It’s for investors who wish to earn extra income on their stock holdings without risking much, provided they are willing to sell their holdings or buy more if necessary.

Strategy Explained

In a covered short strangle, you own the stock and short options on it. This covers the risk of the short call partially because you already own the stock you might have to deliver. The short put is covered by the fact that you have money or wish to buy more stock if the stock price drops.

Breakeven Process

The breakeven points for a covered short strangle are adjusted by the prem

• Upper breakeven: Call strike price + total premiums received.
• Lower breakeven: Put strike price - total premiums received.

For XYZ Corp:

• Upper breakeven: $55 + $4 = $59
• Lower breakeven: $45 - $4 = $41

Sweet Spot

The optimal situation is when the stock price at expiration falls between the two strike prices, so both options expire worthless and you retain the whole premium while retaining your shares.

Max Profit Potential

The maximum profit is limited to the premiums received on the options and any stock appreciation up to the call strike price. If XYZ rises to $55, the profit on stock appreciation would be added to the premiums, with you having additional profits.

Max Loss

The maximum loss is when the stock price falls significantly below the put strike price, minus the premiums received. But unlike a typical short strangle, the loss is mitigated by the fact that you have the stock in your possession. The loss on the put side would be reduced by the depreciating value of your stock holdings.

Risk

The greatest risks are having to sell your stock if the price is higher than the call strike price or possibly having to purchase additional shares at the put strike price if the stock falls. The risk is partially under your control since you have the underlying stock.

Time Decay

Time decay (theta) is to your advantage as the expiration date approaches, as long as the stock is in between the strike prices. With the passage of time, the options lose value, which is a good thing if you are going to keep the premium.

Implied Volatility

Lower implied volatility after the position has been established is desirable because it reduces the possibility of the stock reaching the strike prices, thus reducing the option prices and increasing the likelihood of the options expiring worthless.

Conclusion

A Covered Short Strangle can be an attractive substitute for shareholders looking for additional income in the form of premiums at a risk lower than that of a naked strangle. It is a way to make money from range-bound markets through the use of both option writing and stock holding to balance profit potential with minimal exposure to risk.