Last week I wrote about short strangles and how they offer investors one of the highest-probability strategies on the market. If managed correctly, short strangles are an incredible strategy. But the capital required can be steep for some, so most investors shy away. Plus, the thought of being naked on both sides of a trade (call and put) can potentially lead to a few sleepless nights—that is, if managing risk is an afterthought.
In review, a short strangle is an undefined-risk option strategy that benefits when the asset of your choice stays between your short call and short put strike. In most cases, it’s a neutral strategy with a large price range for the underlying stock to move around in. At least, that’s the way I use short strangles.
[text_ad use_post='261460']
But I want to discuss a slightly different strategy to the short strangle. An alternative that might satiate some investors unwilling to use, for whatever reason, a naked options strategy.
The strategy … a covered strangle.
A covered strangle offers an investor a completely different type of high-probability opportunity. A covered strangle is simply a covered call strategy coupled with a short put–or just buying a stock and wrapping a short strangle around it. Either way, it’s a covered strangle.
Investors want to use a covered strangle when they wish to enhance the returns on a long position (stock or ETF) by two to four times, while also having the opportunity to buy even more shares at a price of their choosing. It’s a great income strategy to use on stocks you already own or wish to acquire.
Let’s go through an example to really get down to the nitty-gritty of how a covered strangle works.
Last week I used Affirm (AFRM) as my example. I realize some of you might not like AFRM, and that’s okay, this is more about learning the step-by-step mechanics of a covered strangle.
Affirm (AFRM) – Covered Strangle
With AFRM trading for 47.26, we are going to buy 100 shares for $4,726.
Once we’ve purchased at least 100 shares we then will sell a delta-neutral short strangle around the shares. Since AFRM is trading for roughly 47, we will look to sell a short strangle that has a delta of roughly 0.10 to 0.30 for both the call and put. Moreover, I will look to go out 20 to 50 days. My preference is to go with a shorter duration for my short strangle, but the amount of premium I can bring in will define my choice of expiration cycle.
Here are our choices for expiration cycles. I’m going to use the May 20, 2022, expiration cycle with 46 days left until expiration.
Once I’ve chosen my expiration cycle, I then must decide which strikes I wish to use for my short strangle.
In most cases, I want to sell a short strangle that has an 80%+ probability of success, or a delta of roughly 0.20 or less.
On the call side:
We can sell the 70 call strike for roughly $1.78. The 70 call strike has a probability of success of 88.43%, or a delta of 0.21.
On the put side:
We can sell the 30 put strike for roughly $1.28. The 30 put strike has a probability of success of 79.27%, or a delta of 0.10.
The Trade
Simultaneously:
- Sell out-of-the-money call
- Sell out-of-the-money put
Sell to open AFRM May 20, 2022, 70 call
Sell to open AFRM May 20, 2022, 30 put for a total credit of $3.06
Premium Return: $3.06 ($1.78 for the call + $1.28 for the put)
A Few Possible Outcomes
Stock Pushes Above Short Call Strike
If AFRM pushes above the 70 short call strike, no worries, we get to keep the put premium of $1.28, the call premium of $1.78 and we make roughly $22 on the stock. Overall, our gain would be $2,500, or 53.2% over 46 days.
Stock Stays Within the Range of 30 to 70
If AFRM stays between our short put and short call we get to keep the entire premium of $3.06, or 6.5% over 46 days. We can use the covered strangle strategy roughly seven more times over the course of the year for a total annual return (just premium) of approximately 45.5%.
Stock Pushes Below our Short Put Strike
If AFRM pushes below our short put strike of 30 we still get to keep our overall premium of $3.06. But we would be issued 100 shares of stock for every put sold. Our breakeven on the newly issued shares would be $26.94, a discount of 43% from the current price of the stock.
To sum up a covered strangle options strategy, if you wish to enhance a stock position, like AFRM, consider this often overlooked but highly flexible covered strangle. You start with the same exposure as a long stock and have protection if the stock moves above or below the stock price. And again, if the stock stays between the short put and short call, you will be rewarded with significantly more premium than with a standard covered call.
As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Newsletter for education, research and trade ideas.