Covered Short Strangle
Description
The Covered Short Strangle is another risky income strategy, though it is certainly
an improvement on the Covered Short Straddle.
The concept is to increase the yield of the Covered Call by selling an OTM (lower
strike) put. In this way we take in the additional income from the sold put; however,
if the stock price falls below the put strike, there is a significant price to pay in terms
of risk.
The sold put adds significant extra risk to the trade. The amount of potential 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 $25 strike call, our risk and breakeven is
$23.00. If we sold a $22.50 strike put for another $1.00, our initial yield on cash would
be doubled. . . but our risk would have increased by another $21.50 ($22.50 $1.00),
making our total risk $44.50 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 can
be in trouble much more quickly.
If the stock falls below the put strike at expiration, the call will expire worthless (so
we keep the premium), the put will be exercised, and we ill have to buy more stock at
the put strike price. With a falling stock, this can be pricey and undesirable. If the stock
is above the call strike at expiration, then we are happy because our sold put expires
worthless, our sold call is exercised, and we simply deliver the stock we already own.
P/L Profile
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