Covered Short Straddle

A Covered Short Straddle is an options strategy that combines elements of 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 generally employed when the trader expects low volatility and believes the stock price will remain relatively stable around the strike price.

The Setup

For example, let's assume you own 100 shares of XYZ Corp, currently trading at $100 per share. You decide to sell a call and a put option both at the $100 strike price, receiving a premium of $5 each. Both options have the same expiration date.

Who Should Consider It

This strategy is well-suited for investors who already own the underlying stock and are looking to generate additional income from their holdings through the premiums received from selling the options. It's ideal 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

By holding the stock and selling a call, you are obligated to sell your shares at the strike price if the call is exercised. By selling a put, you are obligated to buy shares at the strike price if the put is exercised. The covered part comes from owning the stock, which mitigates the risk associated with the short call part of the straddle.

Breakeven Process

There are two breakeven points for this strategy:

Upper breakeven: Strike price + total premiums received.
Lower breakeven: Strike price - total premiums received.

Using our example, the breakeven points would be:

Upper breakeven: $100 + $10 = $110
Lower breakeven: $100 - $10 = $90

Sweet Spot

The sweet spot for this strategy occurs when the stock price finishes exactly at the strike price at expiration ($100 in this example), enabling the trader to keep the entire premium from both the call and the put.

Max Profit Potential

The maximum profit is limited to the premiums received from the options plus any gains from selling the stock at the strike price if above the stock's original purchase price.

Max Loss

The maximum loss is more controlled compared to an uncovered short straddle. If the stock price falls significantly, losses on the stock position increase, but this is partially offset by the profits from the put option premium. The risk on the upside is limited since the stock covers the call.

Risk

The main risk involves the stock moving significantly away from the strike price. However, since the shares cover the call, the primary risk is on the downside, where a significant drop in the stock price could lead to substantial losses, despite the premium 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 offers a way for stockholders to earn income through premium collection while adding a protective layer against downside risk. It's a prudent strategy for those who believe in the stability of their stock's price but also want to hedge against moderate movements. The investor should remain prepared for potential stock assignments and have a plan for either outcome, whether the stock price rises above or falls below the strike prices.