Covered Short Straddle
Description
The Covered Short Straddle is the most risky type of income strategy.
The concept is to increase the yield of the Covered Call by selling a put at the
same strike as the sold call. In this way, we take in the additional income from the
sold put; however, there is a significant price to pay in terms of risk.
First, the sold put adds significant extra risk to the trade. The amount of poten-
tial risk added is the put strike less the put premium received. Say if we trade a
Covered Call on a $24.00 stock, taking in $1.00 for the call, our risk and breakeven
is $23.00. If we sold a put for another $1.00, our initial yield on cash would be
doubled. . . but our risk would have increased by another $24.00 ($25.00 $1.00),
making our total risk $47.00 if the stock falls to zero. Although this is unlikely to
occur in just one month, the position can become loss-making at approximately dou-
ble the speed as a simple Covered Call position, so if the stock starts to fall, we’re in
trouble much more quickly.
Second, with a Covered Short Straddle, we are almost certain to be exercised
because we have shorted both the put and the call at the same strike price. So unless
the stock is at the strike price at expiration, we face a certain exercise, which many
people are uncomfortable with. If the stock is above the strike at expiration, then
we are quite happy because our sold put expires worthless, our sold call is exercised,
and we simply deliver the stock we already own. However, if the stock is below the
strike at expiration, then our call expires worthless, our sold put is exercised, and we
are required to purchase more stock at the strike price. With a falling stock, this can
be pricey and undesirable.
P/L Profile
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