There are many different option strategies that investors can use to generate an income. While covered calls generate an income from an existing long stock position, covered straddles can be helpful for investors that want to initiate a long stock position and generate extra income. The trade-off is that it is a bit riskier than a vanilla covered call strategy.
Let’s take a look at covered straddles, what influences their profitability and how to use them to establish a long position in an underlying stock.
What Is a Covered Straddle?
Covered straddles involve purchasing stock and selling an at-the-money call and an at-the-money put option with the same price and expiration date. The position generates an immediate premium income from the two short options, and if the stock price moves lower, enables investors to average into the stock at a lower price.
Covered Straddle Option Diagram – Source: The Options Guide
- Max Profit: The max profit is equal to the premiums received from selling the two short options. i.e. The income generated from the position. You may also have a small gain if your call is exercised, and you purchased the shares for less than the strike price of the call.
- Max Loss: If the share price dropped to $0, you would lose the funds used to purchase your shares and the cost of your put assignment. There is a greater loss potential since the investor is holding the long stock and short put option. In fact, the losses are 2X leveraged when the stock drops below the put’s strike price.
- Breakeven: The breakeven point is equal to the stock price minus one-half of the total premiums received (since one option necessarily expires worthless).
Both covered straddles and covered calls have downside risk if the stock price declines, but unlike covered calls, covered straddles involve two times normal covered call declines. Your downside is similar to purchasing double the amount of shares initially. Investors should exercise caution when using covered straddles and ensure that they have a plan in place if the stock price moves against their forecast to avoid excessive losses. Keep in mind, it would be very unusual for a stock’s price to drop to $0 in a short period of time.
However, you will devote more capital to the position if the stock’s price finishes below the strike price of the put.
There are a few other dynamics to keep in mind:
- Volatility: Covered straddles are negatively affected by volatility since short options lose money when volatility rises. Since there are two short options involved, the position loses doubly when volatility rises and gains doubly when volatility falls. Changes in price due to volatility are less significant when holding options through expiration.
- Time: Covered straddles are positively affected by the passage of time since the time value in short options deteriorates as time passes. Since there are two short options involved, the position gains doubly with the passage of time.
- Assignment: Covered straddles have an early assignment risk, particularly if there’s a dividend occurring during the holding period or if the price moves significantly. If the position loses value, investors can also accept assignment of the underlying stock.
How to Start a Position
Covered staddles are commonly used to establish a long stock position. For instance, an investor may acquire half the stock they’d eventually like to own and establish a covered straddle where the short put amounts to the other half. If the stock price rises, they generate a profit, and if it falls, they average into the stock position.
Suppose that you want to own 200 shares of XYZ.
You could purchase 100 shares and enter into a covered straddle by selling one at-the-money put and one at-the-money call option. You generate an immediate premium income when entering the position that represents your max profit.
If the stock price rises, the short put expires worthless and the short call caps the long stock’s upside potential. If the stock price falls, the short call expires worthless and the short put obligates you to buy stock at the strike price. You effectively have the same exposure as 200 shares of stock with the premiums received having offset the acquisition cost.
There are a few best practices to keep in mind when using the strategy to acquire stock:
- Events: You should ensure that you understand any market-moving events that may be on the calendar. For instance, earnings and other events can have a significant impact on the volatility and risk associated with the stock.
- Risk Management: You should have a risk management strategy in place to respond to a sudden decline in stock price. The strategy may mimic what you would do if you were already holding the full amount of underlying stock.
There are many variations you can use when using a covered straddle approach. For example, in the Snider Investment Method, we sell the put at 95% of the current price of the stock. By using an out-of-the-money put, there is a buffer before losses are leveraged.
Covered straddles are just one of several option strategies that investors can use to generate an income above and beyond fixed income or dividends.
The Snider Investment Method incorporates short straddles as well as covered calls to create a systematic process of generating an income from options. Using a combination of stock, options and cash, along with specific techniques applied in a specific sequence, the strategy aims to generate consistent monthly cash flow that can help support investors in retirement.
Snider Advisors’ Lattco Trading Platform – Source: Snider Advisors
The strategy helps address many common issues that arise when using covered calls or similar strategies. For example, you’ll have a clear way to identify suitable stocks, choose strike prices and expiration dates and build a diversified portfolio. You’ll also have a well-defined plan in place to manage the position if the stock appreciates or drops in price.
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The Bottom Line
Covered straddles are a popular strategy to generate an income using options, as well as establish a long stock position. While there are greater risks than covered calls, the strategy can be a great way to boost income or acquire stock. The key is selecting the right underlying stocks and managing the risks when the unexpected occurs.
Snider Advisors helps investors generate an income from their portfolios above and beyond fixed income or dividend stocks. Using options and a disciplined method, the strategy seeks to maximize withdrawal rates for retirees so that they can live comfortably in retirement.
Learn more about the Snider Investment Method or discover our asset management options.