covered short strangle

Covered Short Strangle

Post By - Laxmi Mahera
Review By : Rohan Sharma
Updated on : October 26, 2021

Basics Concepts – Covered Short Strangle

Description - Covered Short Strangle

The Covered Short Strangle is another risky income strategy, though it is certainly an improvement on the Covered Short Straddle.
If the stock falls below the put strike at expiration , the call will expire worthless (so we keep the premium), the put will be exercised , and we’ll have to buy more stock at the put strike price.
With a falling stock , this can be pricey and undesirable.
If the stock is above the call strike at expiration, then we’re happy because our sold put expires worthless, our sold call is exercised , and we simply deliver the stock we already own.

Introduction - Covered Short Strangle

Outlook

With covered short strangles, 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 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 a high-risk strategy

Effect of Time Decay

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

Time Period to Trade

Sell the options on a monthly basis.

Breakeven = Varies depending on the relationship between the stock price, premiums received, and the strikes

Steps to Trading a Covered Short Strangle

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 falls below the put strike, your put will be exercised, forcing you to buy more shares at the put strike price. This could become expensive.
If the stock is resting between the strike prices at expiration, then you’ll keep the premiums, but this is a dangerous strategy.

Exiting the trade - Covered Short Strangle

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 stays between the strike prices, 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 strangles are 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.
Less risky than a Covered Short Straddle.

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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