The covered straddle is a bullish strategy in options trading that involves the simultaneous selling of equal number of puts and calls of the same underlying stock, striking price and expiration date while owning the underlying stock. Note that only the call options are covered.
|Covered Straddle Construction|
|Long 100 Shares|
Sell 1 ATM Call
Sell 1 ATM Put
Covered straddles are limited profit, unlimited risk options strategies similar to the writing of covered calls. Another way to describe a covered straddle is that it is simply a combination of a covered call write and a naked put write. Since the naked put write has a risk/reward profile of a covered call, a covered straddle can also be thought of as the equivalent of two covered calls.
|Covered Straddle Payoff Diagram|
Limited Profit Potential
Maximum gain for the covered straddle is reached when the underlying stock price on expiration date is trading at or above the strike price of the options sold.
The formula for calculating maximum profit is given below:
- Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid
- Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Large losses can be experienced when writing a covered straddle when the underlying stock price makes a strong move downwards below the breakeven point at expiration. This is when the covered straddle writer loses not only on the long stock position but also on the naked put.
The formula for calculating loss is given below:
- Maximum Loss = Unlimited
- Loss Occurs When Price of Underlying < (Purchase Price of Underlying + Strike Price of Short Put - Net Premium Received) / 2
- Loss = Purchase Price of Underlying + Strike Price of Short Put - (2 x Price of Underlying) - Max Profit + Commissions Paid
The underlier price at which break-even is achieved for the covered straddle position can be calculated using the following formula.
- Breakeven Point = (Purchase Price of Underlying + Strike Price of Short Put - Net Premium Received) / 2
Suppose XYZ stock is trading at $54 in June. An options trader executes a covered straddle strategy by selling a JUL 55 put for $300 and a JUL 55 call for $400 while purchasing 100 shares of XYZ for $5400. The total premiums received for selling the options is $700.
On expiration in July, if XYZ stock rallies above the strike price to $57, the JUL 55 put expires worthless while the JUL 55 call expires in the money and the 100 shares get called away for $5500, producing a gain of $100. Including the $700 in premiums received upon entering the trade, the total profit comes to $800 which is also the maximum profit attainable.
However, if the stock price drops below the breakeven to $45, the JUL 55 call expires worthless but the naked JUL 55 put and long stock position suffer large losses. The short JUL 55 put is now worth $1000 and needs to be bought back while the long stock position has lost $900 in value. Factoring in the $700 premiums received earlier, the total loss comes to $1200.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).
The following strategies are similar to the covered straddle in that they are also bullish strategies that have limited profit potential and unlimited risk.
Despite its name, the uncovered straddle is not a converse strategy to the covered straddle. Rather, it is the reverse strategy of the long straddle and is also known as the short straddle. Both the long and the short straddles are neutral strategies, which is very different in outlook from the covered straddle which is a bullish strategy.
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