Covered Strangle

Covered Strangle

A covered strangle is an advanced options strategy that combines a covered call and a protective put. It is designed to profit from a stock trading in a range, and it's often employed when an investor believes a stock's price will remain relatively stable. This article will provide a detailed explanation of the covered strangle, its mechanics, risk/reward profile, when to use it, and how to manage it. It is geared towards beginner and intermediate options traders.

Understanding the Components

Before diving into the covered strangle itself, it's essential to understand its constituent parts: the covered call and the protective put.

Covered Call: A covered call involves holding a long position in an asset (typically 100 shares of stock) while simultaneously selling (writing) a call option on that same asset. The investor receives a premium for selling the call option. The maximum profit is limited to the strike price of the call option plus the premium received, less the original cost of the stock. It’s generally considered a neutral to slightly bullish strategy. For further reading on covered calls, see Covered Call.

Protective Put: A protective put involves holding a long position in an asset (again, typically 100 shares of stock) and simultaneously buying a put option on that same asset. The investor pays a premium for the put option. This strategy protects against a downside move in the stock price. The maximum loss is limited to the stock price minus the strike price of the put option, plus the premium paid. It’s generally a bearish hedging strategy. See Protective Put for more details.

What is a Covered Strangle?

A covered strangle combines *both* of these strategies simultaneously. The investor:

1. Holds a long position in 100 shares of the underlying stock. 2. Sells a call option with a strike price *above* the current stock price (a covered call). 3. Buys a put option with a strike price *below* the current stock price (a protective put).

The key characteristic of a strangle is that the call and put options have different strike prices. They are "strangled" around the current stock price. Both options typically have the same expiration date.

Mechanics and Payoff Diagram

Let's illustrate with an example. Suppose a stock is trading at $50 per share. An investor might:

Buy 100 shares of the stock at $50 ($5,000 investment).
Sell a call option with a strike price of $55 for a premium of $1 per share ($100 total).
Buy a put option with a strike price of $45 for a premium of $1.50 per share ($150 total).

The net cost of the strategy is the cost of the stock minus the call premium plus the put premium: $5,000 - $100 + $150 = $4,950.

The payoff diagram of a covered strangle is unique. It shows the profit or loss at different stock prices at expiration.

**Stock Price Below $45:** The put option is out-of-the-money and expires worthless. The call option is also out-of-the-money and expires worthless. The investor's loss is limited to the net cost of the strategy ($4,950) minus any dividends received, less the final stock price.
**Stock Price Between $45 and $55:** Both options are out-of-the-money and expire worthless. The investor profits from holding the stock, offset by the initial net cost. The profit is the stock price minus the net cost.
**Stock Price At $55:** The call option is at-the-money. The put option is out-of-the-money. The investor’s profit is capped.
**Stock Price Above $55:** The call option is in-the-money and is assigned, meaning the investor must sell their 100 shares at $55. The put option expires worthless. The investor's profit is capped at the call strike price ($55) plus the call premium ($1) minus the net cost of the strategy ($4,950) = $56 - $49.50 = $6.50 per share.
**Stock Price At $45:** The put option is at-the-money. The call option is out-of-the-money. The investor’s loss is limited.
**Stock Price Below $45:** The put option is in-the-money. The investor can exercise the put option and sell their 100 shares at $45. The call option expires worthless. The investor's loss is limited to the put strike price ($45) minus the net cost of the strategy ($4,950) = $45 - $49.50 = -$4.50 per share.

The maximum profit is capped, and the maximum loss is also limited. This makes it a defined-risk, defined-reward strategy.

When to Use a Covered Strangle

A covered strangle is most appropriate when:

**Neutral Outlook:** You believe the stock price will remain within a defined range between the strike prices of the put and call options. This is the ideal scenario.
**Moderate Volatility:** The strategy benefits from moderate implied volatility. High volatility increases option premiums, but it also increases the risk of the stock price moving outside the defined range. Low volatility may not provide enough premium income to justify the strategy. Implied Volatility is a critical factor.
**Income Generation:** You want to generate income from your existing stock holdings.
**Limited Downside Protection:** You want some protection against a potential downside move, but you're willing to cap your potential upside.
**Range-Bound Market:** You anticipate a sideways trading pattern for the stock. Trading Ranges are key to success.

Risk and Reward

**Maximum Profit:** Limited to the call strike price plus the call premium received, minus the net cost of the strategy.
**Maximum Loss:** Limited to the net cost of the strategy minus the put strike price. (Note: this is often less than the full cost of the stock).
**Break-Even Points:** There are two break-even points:

   *   **Upper Break-Even:** Call strike price + call premium - net cost.
   *   **Lower Break-Even:** Put strike price - put premium - net cost.

**Time Decay (Theta):** Time decay benefits the covered strangle, as the value of both options decreases as they approach expiration. Theta is a crucial Greek to understand.
**Volatility (Vega):** Changes in implied volatility can affect the strategy. An increase in volatility generally benefits the put option (which you bought) and hurts the call option (which you sold). Vega is another important Greek.
**Directional Risk:** The strategy is vulnerable to large price movements outside the defined range.

Managing a Covered Strangle

**Rolling the Options:** If the stock price is approaching either strike price, you can "roll" the options to a different expiration date or to different strike prices. Rolling involves closing out the existing options and opening new ones. This can be done to extend the range or to take profit. Options Rolling is an advanced technique.
**Adjusting Strike Prices:** If the stock price moves significantly, you might consider adjusting the strike prices of the options to maintain a desired range.
**Early Assignment:** Be aware of the possibility of early assignment on the call option, especially if it goes deep in-the-money.
**Monitoring Greeks:** Regularly monitor the Greeks (Delta, Gamma, Theta, Vega, Rho) to understand the sensitivity of the strategy to changes in the underlying stock price, time, volatility, and interest rates. The Greeks are essential tools for options traders.
**Dividend Considerations:** If the stock pays a dividend, it will reduce the value of the call option and increase the value of the put option. Factor this into your adjustments.
**Profit Taking:** If the stock price remains within the defined range and the options are nearing expiration, you can close the entire position to lock in a profit.