Covered Short Straddle

 

Description

 

The Covered Short Straddle is the most risky type of income strategy.

 

The concept is to increase the yield of the Covered Call by selling a put at the same strike as the sold call. In this way, we take in the additional income from the sold put; however, there is a significant price to pay in terms of risk.

 

First, the sold put adds significant extra risk to the trade. The amount of potential risk added is the put strike less the put premium received. Say if we trade a Covered Call on a $24.00 stock, taking in $1.00 for the call, our risk and breakeven is $23.00. If we sold a put for another $1.00, our initial yield on cash would be doubled. . . but our risk would have increased by another $24.00 making our total risk $47.00 if the stock falls to zero.

 

Although this is unlikely to occur in just one month, the position can become loss-making at approximately double the speed as a simple Covered Call position, so if the stock starts to fall, we’re in trouble much more quickly.

 

Second, with a 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 are 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.

 

Market Opinion

 

Bullish. A rise is expected.

 

P/L Profile

  

 

 

 

 

 

When To Use

 

This is a risky strategy, only to be used if you want to keep your underlying stock.

 

Example

 

XXXX is trading at $28.20 on February 25, 2011.

Buy the stock for $28.20.

Sell the March 2011 30 strike for $2.60.

Sell the March 2011 30 strike call for $0.90.

 

Benefit

 

The opportunity to earn income on the underlying stock if all goes well.

 

Risk vs. Reward

 

Maximum risk is the value of your stock plus the put strike price less the premiums you receive for the call and put sold. This is a high risk strategy. The reward is the generation of monthly income.

 

Net Upside

 

Income being generated on a monthly basis on the underlying stock.

 

Net Downside

 

Unlimited downside potential with this strategy.

 

Break Even Point

 

Strike price minus half of the options premiums received plus half of the difference between the strike price and the stock price.

 

Effect Of Volatility

 

N/A

 

Effect Of Time Decay

 

Positive. Time decay erodes the value of the sold options.

 

Alternatives Before Expiration

 

To stem a loss, sell the stock or sell the stock and buy back the call you sold. If the put is exercised, you will have to buy back the stock at the put strike price.

 

Alternatives After Expiration

 

If the stock price falls under the put strike price, you will be exercised and have to buy more stock at the put exercise price. The calls you sold expire worthless. You keep the premium.

 

If the stock price rises above the call strike price, you will be exercised and make a profit.