Maximizing Income with Covered Strangles: A Comprehensive Guide

Goal: To generate leveraged income from moderately bullish movements in the underlying stock.

Explanation: A covered strangle involves buying (or owning) stock while simultaneously selling an out-of-the-money (OOM) call and an OOM put, all with the same expiration date. This strategy aims to profit if the stock price remains at or above the strike price of the short call at expiration. However, potential losses can be significant and leveraged if the stock price declines below the strike price of the put. Let’s break down the components and risks of this strategy:

1. Example:
   • Buy 100 shares of XYZ stock at $100.00
   • Sell 1 XYZ 105 call at $1.40
   • Sell 1 XYZ 95 put at $1.20
   • Maximum profit: Limited to total premiums received plus the difference between the upper strike price and the stock price.
   • Maximum risk: Substantial and leveraged losses if the stock price falls below the put strike price.
2. Breakeven Point:
   • Stock price at expiration should be either:
     • Above the stock price minus total premiums received.
     • Below the lower strike price plus total premiums received minus the difference between the stock price and the lower strike price.
3. Appropriate Market Forecast:
   • The covered strangle strategy suits a moderately bullish outlook, as maximum profit is achieved if the stock price is at or above the short call’s strike price at expiration.
4. Strategy Discussion:
   • The short put is not truly “covered” as the name suggests, as no cash reserve is held for buying additional shares if the put is exercised. Rather, the long stock position serves as collateral to meet margin requirements.
   • This strategy requires a high risk tolerance and trading discipline, as losses are leveraged on the downside. Traders must adhere to strict guidelines for managing positions when the market moves against their forecast.
5. Impact of Stock Price Change:
   • The net delta of a covered strangle position varies between 0.00 and +2.00 depending on the relationship between the stock price and the strike prices of the options.
   • The position delta approaches +2.00 as the stock price falls below the put strike price, and approaches zero as the stock price rises above the call strike price.
6. Impact of Volatility Change:
   • Rising volatility leads to losses, while falling volatility results in profits. The impact is amplified in a covered strangle due to the presence of two short options.
7. Impact of Time:
   • Time decay benefits the position, with short options profiting from time erosion. The effect is doubled in a covered strangle due to two short options.
8. Risk of Early Assignment:
   • Both the short call and short put carry the risk of early assignment, especially concerning dividends. Traders must evaluate the likelihood of early assignment and take appropriate action.
9. Potential Position at Expiration:
   • If the short call is assigned, the stock is sold at the call’s strike price, and if the put is assigned, stock is purchased at the put’s strike price. Actions must be taken accordingly based on assignment scenarios.
10. Other Considerations:
    • The covered strangle requires aggressive investors willing to tolerate high risk.
    • Tax implications may arise from the short (covered) call, affecting the holding period and tax rate on stock profits. Professional tax advice is recommended.

By understanding the intricacies and risks associated with covered strangles, traders can effectively employ this strategy to generate leveraged income from moderately bullish market conditions.