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The Covered Strangle. No-Brainer or Risky Trade?

Having just blogged about the fact that equivalent positions are truly equivalent, I received this question that's based on the same topic.

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Mark,

I have done covered calls for a while. Looking to increase returns
without taking on much more risk.

Wondering about a covered spread
approach where I own the stock, short OTM calls, short OTM puts, and
enter a stop sell order to automatically liquidate shares if stock hits
my put strike price to cover situation where stock could be put to me.

This seems like a no brainer to enhance returns without anymore risk
but wondering if I've overlooked anything.

Thoughts?

Jason

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You are referring to a covered strangle. This is another example where it's important to understand equivalent positions.

It is NOT a no-brainer.  This has real risk and obviously a very decent reward potential.

Stop-loss

I agree that the stop-loss order does limit risk, but are you aware of how much risk that is, or are you just assuming it's acceptable?

If you are stopped out of the trade, you can lose a substantial sum on the 'no-brainer' put you sold to enhance profits.   That put is now ATM, making it worth substantially more than the premium you received when selling it.  In addition,  IV has probably increased – and that's also going to hurt.  The passage of time is not going to help enough to offset very much of the loss.

Add to that your covered call position.  I acknowledge that if you were going to exit this trade at the same stop loss point, then you are already aware of how much this trade can lose. 

What concerns me is that you entered the stop loss so that 'the stock could not be put' to you.  That's not a good reason for entering a stop-loss order. [As an aside, I believe that stop-loss orders are very inefficient where options are concerned.  You would be forced to enter a market order when the stock is falling, and that's going to get you a very bad fill because you would be paying the asking price when the bid-ask spread is likely to be extra wide.]

Being assigned an exercise notice

First, no one would exercise a put option that is ATM, so there is no immediate danger of being assigned an exercise notice.  The reason for exiting a trade via stop-loss should NOT be to avoid assignment.  It should be because you decided that the loss at that point is enough.   You recognize the trade has not worked and you want to exit.

Second, when you are writing covered calls, having stock put to you is not so bad.  After all, the covered call and naked put represent a similar trade (in your case with different strike prices).  Having the stock put to you doubles your stock ownership and is merely another covered call position that has gone bad. 

Downside risk

When writing an OTM call, I assume you understand that you have downside risk, and that the call offers very little in downside protection.  If you want to get so aggressive as to sell additional naked puts, I suggest you consider that markets do not always rise, and perhaps writing an ATM, or even an ITM covered call instead of your OTM can provide much-needed protection.  Either provides additional (but limited) downside protection, but the downside is where your risk lies.  That protection is needed when you are about to double your position size (by writing extra puts).

It's important that you recognize that writing an OTM covered call is the same position as selling a naked, ITM put. The loss on that portion of your covered strangle is going to hurt when the stock drops several strike prices and you are stopped out of the trade.  When that happens, don't be surprised when you get a bad fill on buying your OTM call with a market order (higher IV and wider bid/ask spread).

Summary

This is far riskier than you imagine.  You have doubled your position size, going from one naked put to (the equivalent of) two naked puts.  Yes the 2nd is more OTM and not likely to result in your being forced to exit – but 'not likely' events occur all the time.

Rethink this.  If you don't 'see' it then please use some graphing software to plot your positions.  Then you can decide whether the extra risk is worth taking.  It may be a good trade for you.  I want you to be aware of the risks before making the trade.  You should also understand the probability of getting stopped out (that's the delta of the naked put you are selling) of the entire trade.

Be careful.  'No-brainer' options strategies don't exist.

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