A covered straddle is created by owning stock and simultaneously buying an at-the-money call and selling an at-the-money put.
Key Takeaways
- A covered straddle is an options trading strategy involving shorting a call and put at the same price level, while also owning the underlying asset.
- The covered straddle, like a covered call, is an investing strategy appropriate for investors expecting little price change before expiration.
- The covered straddle strategy only covers the call option position, thus not providing full coverage.
What is a Covered Straddle?
A covered straddle is a trading strategy that takes advantage of rising stock prices by buying the stock and selling both call and put options. With a covered straddle, an investor has the same number of both call and put options with the same strike price and expiration date.
Why Use the Covered Staddle Strategy
A covered straddle is an investing strategy used to capitalize on a security’s bullish market predictions. High-volume stocks make it simple to create covered straddles. A straddle involves buying and selling a call-and-put option with the same strike and owning the underlying asset. It’s a strategy that works on public exchanges.
How Covered Straddles Work
A covered straddle involves buying stock and simultaneously writing an at-the-money call and an at-the-money put option on the same underlying stock, with the same expiration date. By buying two short options, investors can make money right away. If the price of the stock goes down, they can buy more at a lower cost to average their investment.
Elements of Covered Straddles
Limited Profit Potential
The limited profit potential of a covered straddle is an important factor to consider when investing. This strategy involves buying the underlying stock and simultaneously selling both a call option and a put option with the same strike price and expiration date. The maximum gain for this strategy is reached when the underlying stock price on the expiration date is trading at or above the strike price of the options sold. The formula for calculating maximum profit is given by Strike Price of Short Call – Purchase Price of Underlying + Net Premium Received – Commissions Paid.
Unlimited Risk
Writing a covered straddle is a popular strategy used by investors to take advantage of market volatility. However, it comes with the risk of unlimited losses if the underlying stock price makes a strong move downwards below the breakeven point at expiration. This is because the writer not only loses on their long stock position but also on the naked put. The formula for calculating maximum loss in this situation is given above and involves subtracting the purchase price of the underlying, the strike price of the short put, the net premium received, and commissions paid from twice the price of the underlying.
It is important to note that while writing a covered straddle can be profitable in certain situations, it carries an unlimited risk due to its nature as an options strategy. Therefore, investors should be aware of this risk before entering into any such trades and should always use proper money management techniques when trading options. Additionally, they should also consider using protective stops or other hedging strategies to limit their losses in case of an unexpected market move.
Breakeven Point
The breakeven point is an important concept in options trading, as it represents the price at which a trader can expect to break even on their position. In a covered straddle position, the breakeven point is calculated by adding the purchase price of the underlying asset to the strike price of the short put and subtracting the net premium received. This formula allows traders to determine how much they need to move the underlying asset in order for them to make a profit from their position.
It is important for traders to understand how to calculate their breakeven points, as this will help them determine when they should close out their positions or adjust their strategies accordingly. Knowing when you are likely to break even on your trades can help you manage risk more effectively and maximize your profits. Additionally, understanding how different factors such as volatility and time decay affect your breakeven points can help you make better decisions when it comes to entering and exiting trades.
Examples of Covered Straddle
The covered straddle strategy is a popular options trading strategy that involves selling both a call and put option at the same strike price. In this example, 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 stock for $5400. The total premium received from 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 initial premiums received upon entering the trade, this results in a total profit of $800 which is also the maximum profit attainable with this strategy. However, if the stock price drops below the breakeven point to $45, then both the naked JUL 55 put and long stock position will suffer large losses while the JUL 55 call expires worthless.
Conclusion
The bottom line when it comes to investing is that you want to maximize your return while minimizing your risk. Covered straddles are a popular strategy for investors looking 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.
Covered Straddle FAQ
How risky is covered straddle?
When investing in straddles, the most you can lose is the cost of the straddle plus commissions. This will happen if both options expire without being profitable.
How is straddle covering used?
Staddle covering is commonly used to create a long stock position. For example, an investor may buy half the amount of stock that they would eventually like to own, and create a covered straddle with a short put worth the remaining half. If the stock price goes up, they make a profit, but if it drops, they even out their investment.
Why do straddles fail?
Taking on a straddle position can be risky, especially if the market is dull. In a long straddle, a trader can suffer a great loss when options expire at the money. In this case, the trader must pay the difference between the value of the premiums plus commissions on both trade options.
