Covered Straddles


This post was included in the Economy and your Finances Carnival- June 21, 2009.

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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.

Example:  APPL Straddle
 
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:

Buy 500 shares of IBM
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 Appeal

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.

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4 Responses to Covered Straddles

  1. kbluck 06/03/2009 at 11:30 AM #

    Kudos for continuing to beat the equivalence drum. Traders don’t really understand options until they understand equivalent positions.
    As an additional caution associated with short straddles, some holy grail seekers may also independently come up with the elaboration we talked about previously: the notion of flipping the covering underlying as the market moves through the strike. Be short the underlying if the market price drops below the strike and be long if it goes above it, repeat until expiration. Theoretically, this makes the short straddle completely bulletproof, as whichever side eventually expires in the money will be covered with stock bought or sold at the strike.
    But, as we agreed, this method doesn’t really work well in practice because it requires inhuman 24/7 vigilance to avoid getting caught by big intraday moves or overnight gaps. Even if you manage to avoid missing any moves, you usually end up getting killed anyway by slippage and transaction costs incurred every time the price passes through the strike. Never mind the potential complications of the uptick rule.
    Basically, it only works if the stock refrains from crossing your strike very often, and if it moves through decisively when it does. But what usually happens in the market is that at some point during the cycle the price will linger around the strike, crossing back and forth dozens of times intraday, churning you into a huge loss.

  2. Mark Wolfinger 06/03/2009 at 12:31 PM #

    I like the idea behind flipping the underlying, and agree that it’s far too difficult – and probably too costly, to execute the trades.
    I would make one modification to suit my comfort zone. I would flip less frequently. Perhaps when it moves ITM by a minimum amount (perhaps 25 or 50 cents), or by a fixed percentage (maybe 0.5% on a stock and much less on a high priced index).
    But in the end it’s the same. You try for the minimum number of trades, or the minimum loss for each flip.
    Some months will be good, others will not.
    Thanks for the comment.

  3. Dh 06/04/2009 at 1:15 PM #

    Re Covered straddles:
    Hi Mark:
    Thanks for this article. In this case wouldn’t a simple collar be an acceptable strategy giving more downside protection? Much less profit potential, of course.
    As a separate issue selling a put spread does not protect from a large downside move in the underlying stock (as I have found out to my considerable cost in the past).

  4. Mark Wolfinger 06/04/2009 at 1:27 PM #

    I agree: the collar is far safer. But the trader who submitted the question was a rookie. When shown the trade (he had no idea what it was called, not that that’s important) his eyes boggled. He was amazed at the profit potential.
    Thus, the collar is not anything that would interest this trader – at least not at this stage of his education process.
    Regarding the sale of a put spread:
    a) It does limit losses, but does not provide complete downside protection. Neither does the collar – unless you choose a put that is at the money – a costly undertaking.
    b) When adopting limited loss strategies – such as selling put (and/or call) spreads, that does not remove the need to exercise prudent risk management. Not every trade can be a winner and sometimes it’s best to cut losses so that you never suffer through a large loss.
    I know that’s a simplistic reply, but the truth is that learning how to successfully manage risk takes time. You learn more and more as time passes because you think about the alternatives for adjusting.
    c) The collar is equivalent to selling a put spread (or buying a call spread), when the options have the same strike and expiration date.
    Thus, the collar: buy stock, buy Nov 50 put, sell Nov 60 call is has exactly the same risk/reward potential as
    Buy Nov 50 put and sell Nov 60 PUT. This in turn is equivalent to
    Buy Nov 50 Call, sell Nov 60 call.
    The above is true when options are efficiently priced. Dividends and all interest costs are, or should be, already included in the option prices.

Please share your thoughts.