Dissecting The Covered Strangle

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The covered strangle strategy is a bullish strategy that involves being long 100 shares of stock and selling an out-of-the-money call and an out-of-the-money put. You can also think of it as a covered call with an extra short put.

The strategy is called a covered strangle because the call side of the strangle is “covered” by the long 100 shares.

A normal short strangle has unlimited risk, but in the case of the covered strangle the naked call risk is eliminated by the 100 long shares.

A covered strangle is set up as follows:

Long 100 shares
Short 1 OTM call
Short 1 OTM put

The strategy is structured so that the investor can sell their shares at a higher price, but they are also willing to buy more shares at a lower price.

This is very similar to Step 2 in our Wheel Strategy.

Let’s look at an example that we will discuss in this article.

Date: October 21, 2020

Current Price: $116.87

Trade Set Up:

Buy 100 AAPL Shares @ $116.87
Sell 1 AAPL Jan 15th, 2021 125 call @ $5.90
Sell 1 AAPL Jan 15th, 2021 105 put @ $4.30

Net Cost: $10,667 

Maximum Loss: $21,167

Maximum Profit: $1,833

Breakeven Price: $106.67

Decrease To Breakeven Price: -8.73%

Return Potential: 8.66%

covered short strangle

covered strangle strategy

We can see above that covered strangles are positive delta (bullish), negative gamma, negative vega (short volatility) and positive theta (benefit from time decay).

Very bullish traders would place the short call further OTM. Less bullish traders would place the short call closer to the stock price.

Maximum Profit

The maximum profit for a covered strangle is equal to the distance between the stock price and the short call strike, plus the premium received.

In our AAPL example that is equal to $1,833.

This is calculated as:

Short call strike (125) – Stock Purchase Price (116.87) + Strangle Credit Received (10.20) x 100.

Maximum Loss

The maximum loss for a covered strangle is equal to the cost of the trade plus the risk from the extra short put.

In our AAPL example, the trade cost $10,667. We also have an extra risk of $10,500 from the short put ($105 strike price x 100). Therefore, in this case the maximum loss is $21,167.

Here is the formula to calculate the maximum loss:

In our AAPL example, this can be calculated as:

(116.87 + 105 – 10.20) x 100 = $21,167

Breakeven Price

The breakeven price for a covered strangle is easy to calculate. In our AAPL example this can be calculated as:

(116.87 – 10.20 ) x 100 = $106.67

Let’s assume that AAPL stock finishes exactly at $106.67 at expiry and prove it out.

The $125 strike call is out-of-the-money and will expire worthless.

The $105 strike put is also out-of-the-money and expires worthless.

The loss on the 100 shares is $10.20, BUT we have received and kept $10.20 in option premium, so the position is exactly breakeven.

With a covered strangle, the trade will profit provided that any loss on the share position is not greater than the premium received for selling the call and put.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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