For months I’ve been writing 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, 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.
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.
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A covered strangle options strategy, on the other hand, 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.
But, let’s go through an example to really get down to the nitty-gritty of how a covered strangle options strategy works.
HP Inc. (HPQ) – Covered Strangle Options Strategy
I’m going to keep it simple by using HPQ for our covered strangle example. The stock is due to announce earnings prior to the open tomorrow, so the trade is a bit timely. But, even if you read this after earnings have been announced, the following should be an educational guide on how to properly use covered strangles, particularly when implied volatility is inflated around earnings.
With HPQ trading for 32.25, we are going to buy 100 shares for $3,225.
Once we’ve purchased at least 100 shares we then will sell a delta neutral short strangle around the shares. Since HPQ is trading for roughly 32, 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. Typically, I will look to go out 20 to 50 days. Although since we are trying to take advantage of the inflated volatility or options premium that HPQ is currently offering ahead of earnings, my preference is to go with a shorter duration for my short strangle.
I’m going to use the nearest-term expiration cycle or the November 26, 2021 expiration cycle with 4 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.
But, since we are placing the trade around an earnings announcement I want to place the trade outside of the expected range which in this case is +/- 2.50, or 29.50 to roughly 34.
On the call side:
We can sell the 35 call strike for roughly $0.32. The 35 call strike has a probability of success of 82.15%, or a delta of 0.20.
On the put side:
We can sell the 30 put strike for roughly $0.37. The 30 put strike has a probability of success of 76.35%, or a delta of 0.21.
- Sell out-of-the-money call
- Sell out-of-the-money put
Sell to open HPQ November 26, 2021 35 call
Sell to open HPQ November 26, 2021 30 call for a total credit of $0.69
Premium Return: $0.69 ($0.32 for the call + $0.37 for the put)
Breakeven Price: 29.31
Maximum Profit Potential: $344 ($35 short call strike – $31.56 breakeven =$3.44)x100, or 10.7% over the next 4 days
A Few Possible Outcomes
Stock Pushes Above Short Call Strike
If HPQ pushes above the 35 short call strike, no worries, we get to keep the put premium of $0.37, the call premium of $0.32 and we make roughly $2.75 on the stock. Overall our gain would be $344, or 10.7% over 4 days.
Stock Stays Within the Range of 30 to 35
If HP stays between our short put and short call we get to keep the entire premium of $0.69, or 2.2% over 4 days.
Stock Pushes Below our Short Put Strike
If HP pushes below our short put strike of 30 we still get to keep our overall premium of $0.69. But we would be issued 100 shares of stock for every put sold. Our breakeven on the newly issued shares would be $29.31, a discount of 9.9%.
To sum up a covered strangle options strategy, if you wish to enhance a stock position, like HPQ, 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 feel free to email me or post your question in the comments section below. And don’t forget to sign up for my Free Newsletter for weekly education, research and trade ideas.