At some point, all routs fizzle out. But calling a market bottom is tough. Nonetheless, if traders aren’t positioned for the upswing when the market hits its low, they might miss a precious opportunity. The covered strangle is an option strategy involving both a call option and a put option that can be used to take advantage of such an investing opportunity in a controlled, selective way.
The covered strangle is another option strategy designed to capitalize on high implied volatility (the volatility component of an option’s price) by selling options when they are more expensive than they normally are.
The Covered Strangle Strategy
The covered strangle strategy involves adding a short strangle to a long stock or ETF position, especially when it has had an adverse price movement. With this strategy, traders sell one out-of-the-money (OTM) call option and one OTM put option—i.e. a short strangle—for every 100 shares owned in the underlying.
With the covered strangle, a trader wants to achieve any one of three possible outcomes:
- Buy more shares (at a price below the market price of the shares at the time the strangle was sold).
- Sell shares owned (at a price above the market price at the time strangle was sold).
- Or, profit if the underlying is within a range at expiration.
If the underlying asset falls to be below the strike price of the short put at expiration the call expires and the put is assigned resulting in buying more shares at a lower price. The effective purchase price of the additional shares is the strike price minus the put premium minus the call premium. Since there are two OTM options sold, both can’t be in-the-money at expiration. That means the trader gets to “double dip” on option premium already rich by increased implied volatility. That is to say that both premiums decrease the effective purchase price of the additional shares resulting from put assignment.
Likewise, if the underlying rises to be above the call strike at expiration, the put expires while the call is assigned. The shares that the trader owns are sold at an effective price of the call strike plus the call premium plus the put premium. Again, reaping the benefit of having sold both the call and the put.
If the underlying stock or ETF is between the two strike prices at expiration, both options expire and only the underlying position is left. The two option premiums collected reduce the cost basis of the shares.
When and Why To Consider the Covered Strangle
Here are the things to keep in mind when considering using a covered strangle.
- Position may profit if the security held rises, remains neutral, and maybe even if it declines slightly.
- Position has limited upside potential.
- Traders plan to increase stock or ETF holdings by buying more shares if price falls beneath a fixed price point (resulting from assignment of the short put). The effective purchase price of the shares may (or may) not be at a price below current market value.