The Covered Strangle is both an Income and Investment Strategy

Canadian investors seeking an index or single stock option strategy may want to consider the covered strangle. It can be employed to enhance yield and provide a strategic means to both add to and exit existing positions. Like any options strategy there are trade-offs, and the covered strangle does pose some risk.

The covered strangle, also known as the covered combination, is a strategy composed of two options, a short call coupled with a short cash-secured put and a long underlying stock position. Another way to view this strategy is to look at it as a covered-call position with a short put at a strike below the present value of the stock. The full cost of purchasing 100 additional shares (strike price of short put x100) is deposited in the investor’s brokerage account (cash-secured).

There can be several motivations for employing this strategy. The most obvious reason is to benefit from the time-decay and hence the income of two expiring short option positions on a security that is trading in a narrow range. The covered strangle can also be viewed as an effective trading or portfolio management vehicle. The short call can be sold at a strike price that coincides with a desired profit level or chartist sell-point, and within a time frame that the investor wishes to sell the underlying share(s). The short-put looked at separately, is the price that coincides with the investors’ desire to accumulate additional shares at a price that is consistent with the chartist buying point or the fundamentalist price point based on P/E ratio, dividend ratio or other factors.

Let’s examine the example below:

The investor is currently long 100 shares or will purchase XYZ stock at C$30 with the outlook that XYZ is fairly valued given the present market environment. The investor believes that it is not likely to rise to C$35 in the next 3 months and therefore sells a 35-strike call at price of 90 cents. The short call obligates the seller to sell the stock anytime prior to expiration at a price of 35. At the same time, the investor believes XYZ is a sound company and that he or she would like to add additional shares at a price of C$25. Using the same three-month time period the investor sells a 25–strike put at 60 cents. The short put obligates the seller to purchase the stock at the 25-strike anytime prior to expiration. Note that if the put seller is assigned the actual purchasing price of the stock, it will be C$24.40 due to the offset of the received put premium of 60 cents. Additionally, the investor at expiration keeps the 90 cents received from the short call further lowering the purchase price of the additional shares to C$23.50.

As mentioned in the first paragraph, the strategy is not without risks. The stock could drop precipitously below the strike price and break-even point of the two received option premiums, leaving the investor net long the previous 100 shares plus losses from the short put or the additional 100 shares if assigned.

Any good investor should have a predetermined plan should the investor not wish to be called away on their original long shares or if assigned on the short put. Remember that options can be closed out anytime prior to expiration, so investors may choose to adjust the strikes and or the expiration date of the covered strangle. Additionally, if the investor wishes to be assigned on the short put, he or she may choose to employ a second covered strangle on the additional 100 shares.

MAXIMUM GAIN

Call strike – stock purchase price + net premium received

The maximum gain occurs with the stock at the strike price of call at expiration.

MAXIMUM LOSS

Stock purchase price + put strike – net premium received

The maximum loss occurs if the shares become worthless.

This strategy because of its inherent risk of being doubly long should be used only on stocks or indices that an investor feels are less risky over the long term. The mindset of the investor should be that he or she wants to own the stock at lower levels and is willing to set aside the funds to do so.

One final note, the RRSP and other registered accounts do not allow for cash-secured puts. We will discuss RRSP eligible options strategies in a later article.