CHICAGO (MarketWatch) — One of the basic option strategies stock investors first trade when they make the plunge into option trading is the covered call.
The premise is understandable. I own a stock at $50, I would be happy to sell it at $55. Today someone will pay me $1 to have the right to buy my shares at $55 at any point during the next two months, which would amount to a $5 profit for me. So what’s the catch?
I always remind investors that nothing ever comes free in options; there is always a balance between risks and rewards. The risk to a covered call strategy when compared to a long stock position is the limited upside profit in the stock. That is, the risk of having your stock called away at the strike price. The reward is the previously mentioned premium that the call writer is paid upfront.
There is a less well-known strategy that can increase the amount of premium received for a simple covered call that I have used many times on stocks that are core positions in my portfolio.
This is the covered strangle.
First and foremost, as I just mentioned, nothing comes free with any option strategy. This strategy may not be appropriate for all investors and most importantly, this is a trade that you should only do on a stock you are holding for a reason. Namely, you expect the shares to hold their value over time and expect appreciation. A further qualifier would be that if the shares were to pull back, you would be happy increasing your holding in the name.
How it works
No buy, sell, or hold recommendations here, but for an example of this strategy:
Assume you hold a long position of 200 shares in Amazon.com Inc.
which was trading on Dec. 18, at $127.38 a share. You love the online retailer long term, as the growth in sales and revenue look good as more shoppers click to buy, rather than head out to the malls this holiday season.
In the shorter term, you might be a bit concerned about the high end of the price/ earnings (P/E) ratio range that Amazon is now trading in. You are considering overwriting two calls to generate income and provide a bit of downside protection on this holding. Let’s further assume that you wish you had twice the total share position and are waiting for a pullback in the share price to a lower P/E, to double your position to 400 shares.
This would potentially be great candidate for the covered strangle. Rather than only selling two contracts of the January 135 calls at $2.75, the covered strangle seller will increase the total premium received by also selling the January 115 puts at $1.70. This increases the total premium taken in to $4.45, or an additional 61%.
The strangle is called a covered strangle because the long stock “covers” the unlimited loss to the upside that a naked short call would incur. The short January 115 put to the downside obligates the seller to buy more shares at $115 if the stock price drops below the strike at expiration, but this fits with your longer-term trade strategy to purchase additional shares should the stock pull back. The increased total premium received turbo-charges the yield in each of the potential outcomes when compared to either the covered call or cash-secured put strategy alone.
Scenario analysis (all calculations do not include commissions or regulatory fees):
The stock rises and is called away above 135 at expiration. The total return in this scenario would be equal to an effective selling price of $135 + $4.45= $139.45. This is a gain of $12.07 (less commissions). Divided by the current stock price of 127.38 = 9.48%, which annualized equals 119%. (At the time of this writing, January had 29 days to expiration). The overwrite strategy return, if called away, yields 102% annualized.
The stock falls and you buy 200 more shares due to the short 115 strike put. Here your effective purchase price of the stock is equal to the strike less the total premium taken in, or 115 – 4.45 = $110.55. This represents a $16.83 discount to the current price, or 13.2%.
The cash-secured put alone would equal a purchase price of $113.30, a discount of $14.08, or 11%. Of course, your existing stock position of 200 shares will decrease in value, however.
The stock remains in a range between 115 and 135. The premium of $4.45 is profit. This is equal to a 3.48% return to the stock price, or 43% annualized. The call alone yields profit of $2.75, or 2.16%, 27% annualized.
At this point I want to remind you that nothing is free in options. The downside risk to this strategy is the same as both the covered call strategy to the upside, limiting the returns if your stock is called away at strike, as well as the same as the cash-secured put to the downside, being forced to buy stock at the strike price should the shares fall. However, by putting both strategies together on stocks you own, the covered strangle will likely offer additional income generated from the option positions in your portfolio.
View more information: https://www.marketwatch.com/story/spicing-up-options-trades-2010-01-04