Covered Short Strangle

The Covered Short Strangle is a variation of the basic short strangle, designed to limit risk by owning the underlying asset while simultaneously selling a call and a put option. This strategy is employed when a trader expects minimal price movement in the underlying asset but seeks to enhance returns through premium collection, with a buffer against losses provided by ownership of the stock.

The Setup

Let's say XYZ Corp is trading at $50 per share. You already own 100 shares and decide to implement a covered short strangle by selling a $55 strike call for $2 and a $45 strike put for $2, both expiring in three months. The total premium received is

$4.

Who Should Consider It

This strategy is suited for investors who already hold the underlying stock and expect it to trade within a certain range. It's ideal for those looking to generate additional income from their stock holdings without incurring significant risk, as long as they are prepared to potentially sell their shares or buy more.

Strategy Explained

In a covered short strangle, you own the stock and write options against it. This covers the risk of the short call to some extent since you already own the stock that you might have to deliver. The short put is covered by the fact that you have the financial means or desire to buy more shares if the stock price falls.

Breakeven Process

The breakeven points for a covered short strangle are modified by the premiums received:

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 ideal scenario is when the stock price at expiration is between the two strike prices, allowing both options to expire worthless and you to retain the full premium while still holding your shares.

Max Profit Potential

The maximum profit is limited to the premiums received from the options plus any appreciation in the stock up to the call strike price. If XYZ rises to $55, the profit from stock appreciation would add to the premiums, providing additional gains.

Max Loss

The maximum loss occurs if the stock price falls significantly below the put strike price, minus the premiums received. However, unlike a standard short strangle, the loss is mitigated by the fact that you own the stock. The loss on the put side would be offset by the declining value of your stock holdings.

Risk

The primary risks include having to sell your stock if the price exceeds the call strike price or potentially buying more shares at the put strike price if the stock falls. The risk is somewhat controlled because you own the underlying asset.

Time Decay

Time decay (theta) benefits this strategy as the expiration date approaches, provided the stock remains between the strike prices. As time passes, the options lose value, which is advantageous if you intend to keep the premium.

Implied Volatility

Lower implied volatility following the establishment of the position is beneficial because it reduces the likelihood of the stock reaching the strike prices, thereby decreasing the option prices and increasing the likelihood of the options expiring worthless.

Conclusion

A Covered Short Strangle can be a practical approach for stockholders looking to make additional income from premiums with reduced risk compared to a naked strangle. It provides a strategy to benefit from range-bound markets, leveraging both option writing and stock ownership to achieve a balance of profit potential against moderate risk exposure.