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Are you curious about new ways to bump up your gain from stock investments? Covered strangle options trading might be the strategy you didn’t know you needed. This trading secret can help you yield income in a modestly bullish market, leveraging your existing stock holdings for better returns. Inquisitive? Continue reading to see how this approach functions and how it can help your portfolio of investments.
Covered strangle options- What is it?
A covered strangle options trading strategy calls for holding onto the underlying asset while concomitantly selling an out-of-the-money (OTM) put option and an OTM call option. Basically, you sell a higher call and own the stock. You also sell a put at a strike price that is lower.
In simpler terms, you’re granting someone else the right to purchase your stock at an elevated price and sell it at a lower price. Both options share the same expiration date. The approach is helpful if you believe that the stock price will stay mostly steady over time.
The goal is to earn income from premiums. The premiums are yours to keep if the price of the shares remains between the two strike prices and both options expire worthless. This can effectively provide additional returns on a stock you already own.
This strategy is typically seen as bullish. Investors employ it when they believe the stock price will rise soon. In addition, it can act as a protection against possible downside risk. If you expect the stock price to increase but seek protection in case it falls, this strategy can be ideal.
Covered strangle options example
To understand a covered strangle options trading strategy, let’s dive into an example using shares of ZZZ Company.
You buy:
100 shares of ZZZ Company at ₹600 per share.
You sell:
- An OTM call option that would yield a premium of ₹20 per share at a strike price of ₹650.
- An OTM put option with a strike price of ₹550, earning a premium of ₹15 per share.
The lot size for each option is 50 shares.
Premiums received:
- Call option: ₹20 x 50 = ₹1,000
- Put option: ₹15 x 50 = ₹750
- Total premiums received: ₹1,000 + ₹750 = ₹1,750
Break-even points:
There are two break-even calculations depending on whether the stock price minus the lower strike price is greater than or less than the total premiums received.
- Upper break-even: Strike Price of Short Call + Net Premium Received = ₹650 + ₹1,750 / 100 shares = ₹667.50
- Lower break-even: Strike Price of Short Put – Net Premium Received = ₹550 – ₹1,750 / 100 shares = ₹532.50
These points indicate that if ZZZ Company’s stock price is between ₹532.50 and ₹667.50 at expiration, the trade will result in a profit.
Maximum profit:
Maximum profit is achieved if the stock price is at or above ₹650 at expiration. The profit comprises the total premiums received plus any gains from selling the stock at the upper strike price.
- Profit from call option premiums: ₹20 x 50 = ₹1,000
- Profit from put option premiums: ₹15 x 50 = ₹750
- Profit from stock appreciation: (₹650 – ₹600) x 100 = ₹5,000
- Total maximum profit: ₹1,000 + ₹750 + ₹5,000 = ₹6,750
Maximum loss:
Maximum loss happens when the price of the shares drops dramatically below ₹550. The loss calculation involves the difference between the stock purchase price and the lower strike price, minus the premiums received.
- Loss from stock depreciation: (₹600 – ₹550) x 100 = ₹5,000
- Subtract net premiums received: ₹1,750
- Total maximum loss: ₹5,000 – ₹1,750 = ₹3,250
Covered strangle options trading strategy pros and cons
Pros:
- Additional income: Selling an out-of-the-money (OTM) call and put generates premiums, boosting overall returns.
- Profit from stability: The strategy profits as long as the stock price remains within the range of the strike prices.
- Lower volatility sensitivity: Less affected by volatility changes compared to a covered straddle.
- Downside protection: Premiums received can offset small declines in the stock’s price.
Cons:
- Significant loss risk: Major losses because both long stock and short put bets lose value if the stock price drops below the lower strike price.
- High tolerance for risk: Requires handling leveraged downside risk and adhering to strict guidelines for managing losses.
- Early assignment risk: If the call option buyer exercises their right to purchase the shares at the strike price before expiration, they will compel you to sell.
- Complexity: Needs a disciplined approach to risk management and a solid grasp of options trading.
Bottomline
The covered strangle options trading strategy offers a balanced approach for investors looking to boost their stock holdings’ returns. It helps investors boost returns on their stock holdings. Premiums are earned when you sell both a put and call option. This approach provides some level of downside protection.
However, understand the risks involved, especially potential losses. These losses occur if the share price drops below the lower strike price.
This strategy is best for investors expecting stable prices. It also works if you foresee modest price rises. Covered strangle options can be useful to your financial toolkit if you manage them carefully and have a solid understanding of their principles. Always consider your risk tolerance and investment objectives before implementing this strategy.
FAQs
A covered strangle can be a good strategy for earning additional income if you believe the stock price will stay relatively stable. By selling an out-of-the-money call and put option, you earn premiums while owning the stock. This strategy offers downside protection but carries the risk of significant losses if the stock price falls below the lower strike price. It’s suitable for investors with a good understanding of options trading.
The primary risk of a covered strangle is significant losses if the stock price falls below the lower strike price. In this scenario, you face losses from both the stock’s depreciation and the short put option. Additionally, there’s the risk of early assignment, where the buyer of the call option may exercise their right to buy the stock before expiration, potentially forcing you to sell. Understanding and managing these risks is crucial for this strategy.
A strangle option involves buying both an out-of-the-money (OTM) call and put option on the same stock with the same expiration date. For example, if a stock is trading at ₹600, you might buy a ₹650 call option and a ₹550 put option. If the stock price moves significantly in either direction, you profit from one of the options. This strategy benefits from high volatility, as large price movements increase the chances of profit.
A covered call strategy can be profitable if the stock price remains relatively stable or increases slightly. By selling call options, you earn premiums, which provide additional income. However, if the stock price rises significantly, your profit is capped at the strike price, and you might miss out on higher gains. Conversely, if the stock price falls, the premium can help offset some losses, but not entirely.
Covered options involve holding the underlying asset when selling options. For example, in a covered call, you own the stock and sell a call option against it. This provides some protection because you already own the asset, reducing risk if the option is exercised. In contrast, uncovered options do not involve holding the underlying asset. When selling a naked call or put, you don’t own the stock, exposing you to significant risk if the market moves against you.