Covered short straddle

Covered Short Straddle

Post By - Laxmi Mahera
Review By : Rohan Sharma
Updated on : October 25, 2021

Basics Concepts – Covered Short Straddle

Description - Covered Short Straddle

The concept is to increase the yield of the Covered Call by selling a put at the same strike as the sold call.
Covered Short Straddle, we are almost certain to be exercised because we have shorted both the put and the call at the same strike price.
So unless the stock is at the strike price at expiration, we face a certain exercise, which many people are uncomfortable with.
If the stock is above the strike at expiration, then we’re quite happy because our sold put expires worthless, our sold call is exercised, and we simply deliver the stock we already own.
However, if the stock is below the strike at expiration, then our call expires worthless, our sold put is exercised, and we are required to purchase more stock at the strike price.
With a falling stock, this can be pricey and undesirable.

Context - Covered Short Straddle

Outlook

With covered short straddles, your outlook is bullish. You expect a steady rise.

Net Position

This is a net debit transaction because you are paying for the stock and are only taking in small premiums for the sold put and call options.
Your maximum risk is the price you pay for the stock, plus the (put) strike price, less the premiums you receive for the sold call and put. This is high risk.

Effect of Time Decay

Time decay is helpful to your trade here because it should erode the value of the options you sold.

Time Period to Trade

Sell the options on a monthly basis.

Breakeven = (Strike price – half the premiums received + half the difference between stock price and strike price)

Steps to Trading a Covered Short Straddle

Steps In

Try to ensure that the trend is upward or range bound and identify a clear area of support.

Steps Out

Manage your position according to the rules defined in your Trading Plan
If the stock closes above the strike at expiration, your call will be exercised.
If the stock remains or falls below the strike, your put will be exercised, forcing you to buy more shares at the strike price.
If the stock is resting at the strike price at expiration, then you’ll make a profit – but this is a highly risky strategy

Exiting the trade - Covered Short Straddle

Exiting the Position

If the share rises above the (call) strike price, you will be exercised at expiration (or before) and therefore make a profit.
If the share falls below the (put) strike price, you will be exercised at expiration (or before) and will have to buy more stock at the put exercise price. Your sold calls will expire worthless, and you will keep the premium.
If the share is at the strike price at expiration, you will have successfully reduced your cost of entry because the premiums you took in will offset the price you paid for the stock.

Mitigating a Loss

Either sell the share or sell the share and buy back the call option you sold.
If the put is exercised, then you will be required to buy the stock at the put strike price.
Please note that Covered Short Straddles are highly risky, and you should ensure that you have enough cash in your account to fulfill the exercise obligations you may have on the downside.

Advantages and Disadvantages

Advantages

Generate monthly income.
Greater income potential than a Covered Call.

Disadvantages

Very risky if the stock falls.
Expensive strategy in terms of cash outlay.
Capped upside if the stock rises.
Uncapped downside potential.
This is not a recommended strategy.

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