This post was included in the Economy and your Finances Carnival– June 21, 2009.
A recent comment prompts me to write about a very attractive-looking strategy, the covered straddle. This method is often chosen by option rookies, believing they have discovered one of the 'best' option trading ideas.
A straddle is a position in which an investor buys or sells both a put and call on the same underlying, with the same strike price and expiration date.
Long straddle: Buy 5 AAPL Jul 140P and 5 Jul 140C
Short straddle: Sell 3 AAPL Oct 135P and 3 Oct 135C
When you sell the straddle and own enough shares to cover the call options (i.e., you own enough stock to deliver, if you are assigned an exercise notice on the calls), then the position is known as a covered straddle.
Thus, an example of a covered straddle:
Sell 5 Oct 100 calls
Sell 5 Oct 100 puts
What's the appeal of this strategy? Is this a good strategy for you?
The numbers look great, especially when trading highly volatile, risky stocks. In fact, many option newbies think of this strategy as a gift (free money). Isn't not, but let's work through this more slowly.
As of yesterday's close, you could buy SVNT (the stock used by the commenter) at 7.07 and sell the Jun 7.50 straddle @ $3.30.
If SVNT is above 7.50 when expiration arrives, you are assigned an exercise notice on the calls and sell stock @7.50. Adding the $3.30 premium, gives you a net selling price of 10.80 – and a net profit of $3.73 per spread, before commissions. The appeal of that > 50% return is so attractive that too many rookies jump right in, place the trade, and fail to recognize that news must be pending, due to the high option prices.
If the stock remains below 7.50 at expiration, then the investor is assigned an exercise notice on the puts, and buys stock at $7.50 – minus the $3.30 premium. Net cost: $4.20.
Looks great. The options are priced this high for a reason. Most covered straddles do not present such attractive looking numbers.
Is this a good strategy for you?
Probably not. Here's why: I must remind you that lessons learned earlier still hold true. One of the important aspects of learning to trade options is understanding that some positions are equivalent to others.
When you own a covered straddle, the position can be broken down into two parts: a covered call plus a naked put. In case you don't remember, a covered call is a naked put. Thus, the attractive-looking covered straddle trade is equivalent to the sale of two naked put options.
I've written about naked puts previously, and my recommendation is that this strategy is appropriate for investors who want to accumulate stock positions over time – but that it's too risky for short-term traders who are looking for trading opportunities. For those investors and traders, I recommend the less-rewarding, but far less risky sale of put spreads, rather than the sale of naked puts.
Thus, this covered straddle is the same as selling two naked puts – and that's fine, if writing naked puts suits your comfort zone and trading style. Don't make this trade just because the naked puts are disguised as a covered straddle.