Options Theory: The Covered Strangle
What happens when you combine two sweet strategies? You get a position that’s a hybrid of, well, two sweet strategies.
What if a naked put and a covered call fell in love and had a baby?
It would be a covered strangle.
Now, what if a short strangle and long stock fell in love and had a baby?
It would also be a covered strangle.
We can follow either combination when wrapping our head around the covered strangle strategy. Here’s how I would think about the first. You buy 100 shares of AMD at $10.11 and sell a June $11 call for 52 cents. The short call provides cash flow at a rate of $1 per day (that’s the theta). Further, the max profit is $1.41 because you can capture an 89 cent gain on the stock if it rises to the call strike of $10.50, plus the 52 cent premium.
That’s $1 in daily theta gains and a potential return on investment of 15% (formula: $141/$959). It’s double that, or 30% in a margin account ($141/$480). DANG GINA!
Now, suppose to elevate your gaming of time decay you also decide to sell a June $9 put for 35 cents. In doing so, you obligate yourself to buy another 100 shares at a cost basis of $8.65. But that’s only if the put sits in-the-money at expiration. If it doesn’t, you’ll capture another $35 in premium for your troubles. That translates into another $1 per day in theta gains.
Yes indeed, by adding the short put to the covered call you’re officially double dipping. I guess. But here’s the catch. You’re also increasing the risk and therefore cost of the position. No free lunches, remember? The extra collateral required for the naked put in a margin account is $92. So, here’s the official tally:
Premium collected: 52 cents from covered call + 35 cents from naked put
Initial capital required in a margin account: $480 + $92 = $572
Maximum potential reward if stock lifts above $11 (call strike): $176
Theta: $2 per day
Master traders seeking higher theta exploitation will often add naked puts to a covered call position. But their gambit isn’t magic, nor does it warp the laws of risk and reward. They’re taking more risk, and they’re garnering more potential reward. Perhaps the best way to illustrate is to, well illustrate. I’m talking about risk graphs; the best visual there is for seeing what an instructor is saying. We’re turning numbers into pictures.
First, here’s a comparison of what the naked put and covered call risk graphs look like. Note how the $11 covered call has more potential profit (and thus, theta) but requires a more significant rise in the stock. The $9 naked put chips in less potential profit but will have a higher probability of success.
Now, the combined position, the baby of this here lovely couple, is shown below:
The two “points” in the risk graph represents the strikes at $11 and $9. If the stock sits between both strikes you will capture the max gain on the naked put, but a partial profit on the covered call. Above $11 will net you the max gain on both positions.
How would you manage this position? The same way you would typically handle a covered call or naked put trade independently. On the target side, I suggest buying back the put once you capture the majority of the gain. If you don’t want to be assigned on the call, then repurchase it if it moves in-the-money and the time value runs out.
If the stock tanks you could a) allow assignment on the naked put, b) roll out, or c) close it before expiration to avoid assignment.
For the covered call, you could roll down (or down and out) the call to bring in more premium.
Try this pup out and let us know what you think.
