Question about an option strategy...

Discussion in 'Options' started by Breakout, Aug 20, 2003.

  1. A guy was asking me about an option strategy he calls "Covered
    Straddle". Personally, I wasn't that impressed with the strategy.

    Do any of you guys do this? Is there any advantage to owning the stock? Thanks

    Here's how it works...Investing Strategy: Covered Straddle


    If you have a trading range prediction for a particular stock, then an option strategy known as the "covered straddle" can be used to trade the price range you forecast.

    Consider the following situation: (1) you currently hold 300 shares of XYZ stock at $55. (2) If the price rallied to $60, you would sell those shares and realize your profits. (3) If, however, the price dipped to $50, then you would purchase 300 additional shares. It is assumed, of course, that you have cash available to purchase the additional shares. Important: the calculations presented below do not include commissions or taxes, which will affect your actual returns on any such strategy.

    Rather than enter limit price stock orders to sell 300 shares at $60 and to buy 300 shares at $50, you could use the following option strategy:

    Sell 3 XYZ 55 Calls @ $3.00 and Sell 3 XYZ 55 Puts @ $2.50

    Note that both of these options are covered. The obligation of the short calls is covered by the owned shares, and the obligation of the short puts is covered by the cash on deposit. Hence the name "covered straddle."

    Assume these options have about 2½ months to expiration. Also assume that neither option has been assigned early, a risk of selling American-style options. Now fast forward to expiration. The price of XYZ stock will either be above $55, below $55 or at $55. Let's consider each outcome.

    If the price of XYZ is above $55 at expiration, the 55 Puts will expire, and the 55 Calls will be assigned. As a result of the assignment you will be required to sell your 300 shares at the strike price of $55. But don't forget the option premiums! Since a total of $5.50 per share was received, the "effective price" of selling the stock is calculated as follows:

    Effective Selling Price of Stock =

    Strike Price of Call + Call Premium + Put Premium = 55 + 3 + 2.50 = 60.50

    The price of $60.50 is slightly higher than the initial objective of $60. In this outcome, therefore, our objective of selling at $60 has been met. Note that the price of XYZ does not need to be at $60.50 to be sold at $60.50. In this example, the price simply needs to be above $55 at option expiration. Achieving this objective has been made easier through the use of options!

    In the second possible outcome, a stock price below $55 at expiration, the calls expire worthless and the puts are assigned. This means that you will be required to purchase an additional 300 shares at $55. The premium from the sold options, however, lowers the effective purchase price as follows:

    Effective Purchase Price of Stock =

    Strike Price of Put - Call Premium - Put Premium = 55 - 3 - 2.50 = 49.50

    In this outcome, the objective of buying 300 shares at or below $50 is achieved. Furthermore, the stock price does not need to be at or below $50 for this result to be achieved. The stock price simply needs to close below $55 at expiration.

    In the third outcome, a closing stock price of exactly $55, both options expire worthless, and the total premium, $5.50 per share in this example, is kept as income.

    It is, of course, possible that the price of XYZ could be substantially above $60 or substantially below $50. At that point you might think that "doing nothing" would have been a better strategy. That is the beauty of hindsight. But if we have the courage of our convictions, then we must ask, "Were our objectives met?" If the answer is, "Yes," then the next question is, "What role did the options play?" The answer to that question is that the options simply helped us meet our objectives.
     
  2. vega

    vega

    1) I'm assuming that if you had the cash to purchase another 300 shares at 50 that you will be able to cover the margin of being short the straddle.

    2) You are also saying that you are very comfortable being long the stock at $49.50--regardless of where it is trading (<49.50)--the main problem with being short options.

    3) Was this strategy proposed by a broker, ringing up double commissions on the short call and put ?

    4) Obviously it would be a huge winner, but what would your course of action be on expiration day if the stock was trading right at 55 ? You could buy back both the call and put, probably paying .50, and still profit $5, but you would definitely want to close that position out to avoid pin risk.

    5) Personally, I don't really know what to say about this, I mean if you believe that the stock is going to be in a range, sure, then being short the straddle is a great way to go, if you want to buy more stock at $50, which you're already long from higher (see avg. down/throwing good money after bad), wouldn't you rather just bid $50, and buy it if it gets down there as opposed to having it gap lower and being obligated to buy it at a price of 49.50 after premium ?

    Who knows, doesn't sound horrible, but don't sound that great to me either.


    Vega:D
     
  3. def

    def Interactive Brokers

    Agree with vega. the strategy is fine. however, if you think it is range bound you are probably looking at low beta stocks. Thus the premium you get from selling may not make the trade attractive.
     
  4.  
  5. ktm

    ktm

    To put it another way...

    If you are getting that much premium, the stock probably isn't going to be rangebound.
     
  6. vega

    vega

    If you can sell the call for $3, then buy 300 shares at 55, sell 6 55 calls at $3, giving you the exact same risk parameters, and a net price of $49 on the last 300 shares:p beat your strategy by a whopping .50 !!!!!!!!!!!!!!!!!!!

    Just kidding, but if the stock ain't gonna move, you ain't getting 3 bucks for the calls, hehehe. Just be very careful when selling options, if the premiums are high, there's probably a reason.:eek:

    Vega:D
     
  7. Thanks guys, I just told him not to bother with it unless he plans
    on buying more stock anyway, and holding it for the long term.

    If he just wants to trade, then just go naked on both ends( a straddle or strangle) and don't bother with purchasing the stock.

    And of course, keep you're losses small.
    :D