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What Are Options | The Covered Strangle Strategy

Updated on May 23, 2012

Buy And Hold | Increase Returns With A Covered Strangle

The most basic investing strategy is to “buy and hold”. The buy and hold investor simply purchases stock in what he believes is a great company and holds it for an extended period of time. In fact, the buy and hold strategy is advocated by the greatest investor of all time, Warren Buffett who has been quoted saying “My favorite holding period is forever”. During this lengthy holding period the investor usually collects dividend income which can then be reinvested by purchasing additional shares. Over time the investor is able to accumulate a large position in the company which then generates substantial dividend income and hopefully has appreciated in price. However, buy and hold investors that wish to increase returns might want to consider the covered strangle options strategy. The options covered strangle can be applied by investors to generate more income while they wait for long term stock price appreciation.

Buy and Hold
Buy and Hold | Source

How Does The Covered Strangle Work For Buy And Hold Investors?

Since the investor already has purchased a position in the underlying security, he basically waits for time to pass while he collects dividend income and purchases more shares. This type of investing is passive and can take many years to generate substantial income. However, if one wants slightly more involvement and increased income from a buy and hold position, the covered strangle might be a perfect fit. The basic goal of the buy and hold strategy is to generate income for retirement. Thus, the better performance of one’s portfolio now, the less time it takes to accumulate enough wealth for retirement. Therefore, the covered strangle strategy could be used to maximize returns and can be utilized hundreds of times throughout the course of the investment period. Over time, the income earned from the covered strangle will accumulate and increase overall investment returns. However, the covered strangle strategy does subject the investor to an increased amount of risk.

The Covered Strangle

Prior to delving into this options trading strategy, a solid understanding of how call options and put options work is essential. The covered strangle, also known as the covered combination, is a limited profit, unlimited risk options trading strategy that involves selling a covered call while simultaneously selling a put with the same expiration date, on the same underlying security, which the investor already owns in his portfolio. Both the call and put contracts should be “out of the money”. The sale of both contracts thus generates immediate income from both premiums. The sale of the put option adds significant risk to the trade because if the stock price were to dramatically decline one could be forced to purchase the underlying stock at the strike price of the put contract. The maximum profit occurs when both the call and put expire worthless and the investor retains his original position in the underlying company while pocketing the premiums received.

When one buys a stock for the long haul he must be comfortable holding the stock for many years. However, the size of the position can vary throughout the course of the investment period, increasing and decreasing as the investor sees fit. While harboring the stock numerous occasions should arise in which one can establish a covered strangle to increase the return on investment. For the strangle to work, one must already own the stock, preferably around 500 shares or more.

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An Example Covered Strangle Using a Buy and Hold Position

For the covered strangle to work you need to start with position size that you are comfortable holding in the underlying stock. For this example lets make the following assumptions:

  • You like the company Activision Blizzard and think that the video game business will thrive in the next 5 to 10 years.
  • You have been buying ATVI stock slowly over the years and have accumulated 1,000 shares.
  • You are comfortable owning between 500 and 1500 shares of ATVI

At the current market price your investment in ATVI is worth $11,650. You believe in the long term growth of this company and have no intention of selling your entire stake but will allow your position alter between around 500 and 1500 shares. Therefore, assuming you have 1,000 shares of ATVI you could sell 5 out of the money covered calls and 5 out of the money puts. You can pick the month in which you want the contract to expire, for this example we will use May 21, 2011. Currently, the sale of 5 May 21, 2011 13.00 call options will generate $115 (23X5) and the sale of 5 May 21, 2011 10.00 put options well generate $105 of immediate income. The total premium received for this covered strangle is $220.


Covered Strangle Outcomes

This trade is has a number of possible outcomes. Let's examine the possiblities:

  1. At market close on May 21st, 2011 ATVI might be trading for $15/share. In this case the 5 call options that were sold will be "in the money" and your broker will remove 500 shares of ATVI from your account and deposit $6,500 cash. Therefore, the sale of the covered calls has limited the ability of 500 shares to profit after the 13 strike price. However, after exercise you will still have 500 shares remaining and you could simply buy more ATVI on the next dip.
  2. At market close on May 21st, 2011 ATVI might be trading for $8/share. In this case the 5 put options that were sold will be "in the money" and you will be required to buy 500 shares of ATVI at the 10 stike price, which will cost $5,000. However, since you received $220 in premiums your actual purchase price will be $9.56/share and you will be at your maximum position size of 1500. The sale of the put option has increased your risk and now you have a larger ATVI position.
  3. At the market close on May 21st, 2011, ATVI might be trading for $12.20/share. In this case the 5 call contract and 5 put contracts expire worthless, netting you the $220 premium and keeping your initial 1,000 shares. You can simply repeat his process every few months, a process known as rolling. During this time period you also keep any dividends paid out by the company.


Conclusion

The covered strangle when used with the buy and hold mentality can generate substantial additional income over extended periods of time. Of course, the sale of a put option can force you to purchase more of the stock.  Keep the number of puts sold equal to the amount of stock you are comfortable purchasing. To limit the risk of the trade one should sell near term out of the money contracts that will have less time to experience wide price swings. The goal of this strategy is to generate additional income and the process can be repeated as long as you hold your stock position. Over time, this strategy can generate large returns.

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      Shweta 

      3 years ago

      For December I plan on undertaking NaBloPoMo (AGAIN), spindeng more time with my family, look into photography classes and maybe take up drawing (again).And while I don't own a pea brained cat I do own a pea brained dog who forgets who you are if you leave the house for more than a day

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