What is Covered Strangle Options Trading?
The Indian stock market is as simple as it gets: you buy stocks at a low price and sell them when the price is higher and make profits based on the price difference. However, new investors do not give much attention to detailed analysis and see their investments plunge when the stock market takes a falls. It is then that they wonder how successful investors make profits even when the stock market is falling and are introduced to different asset classes such as Options.
An Options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without having to buy/sell the contract. Professional investors use Options contracts to hedge against the stock market and make profits even when their investment in stocks are falling. But, how?
There are numerous Options strategies used by experienced investors that give them exposure to stocks and still limit their risk factors while providing a better return. One such strategy is Covered Strangle Options Trading Strategy..
However, you should first learn about some common terms included in the execution of a Covered Strangle Options Trading Strategy.
Some terms associated with Covered Strangle Options Trading Strategy.
Strike Price: The price at which the options contract was initially bought or the pre-determined price.
Spot Price: The current price of the underlying asset is attached to the option contract.
Premium: It is the price you pay to the seller of the option for entering into the online trading options.
In-The-Money (ITM) call option: When the underlying asset price is higher than the strike price.
Out-of-the-money (OTM) call option: When the underlying asset price is lower than the strike price.
What is the Covered Strangle Options Trading Strategy?
A Covered Strangle Options Trading Strategy is where the investor buys stocks of a company and then sells an out-of-the-money call and an out-of-the-money put simultaneously. The Covered Strangle Options Trading Strategy is implemented when a trader thinks that the stock price might go above the strike price of the short call at the time of expiry. In this strategy, the two contracts have the same expiration date and underlying asset. The strategy gets its name because the upside risk is covered or minimized because of the execution of the short call.
How does Covered Strangle Options Trading work?: Covered Strangle Options Strategy (Guide + Examples)
The covered Strangle Options Trading Strategy is explained in the following detailed example:
Suppose the shares of XYZ are currently trading at Rs 500. To execute a Covered Strangle Options Trading Strategy, you buy 100 shares of the company and sell an OTM Call at the strike price of Rs 550 at a premium of Rs 15. Simultaneously, you sell another OTM Put at a strike price of Rs 450 and a premium of Rs 10 per share. The lot size is 50 and the expiration date and the underlying asset is the same.
Premium Received from Call Option: 15x50 = Rs 700
Premium Received from Put Option:10x50 = Rs 500
- Upper: Strike Price of Short Call + Net Premium Received = Rs 550+ Rs 15 = Rs 565
- Lower: Strike Price of Short Put - Net Premium Received = Rs 450 - Rs 10 = Rs 440
Maximum Profit: Maximum profit in the case of Covered Strangle Options Trading Strategy is limited to total premiums received plus upper strike price minus stock price. In this case, the maximum profit will be (15+10) + (550-500)x50 = Rs Rs 3,750.
Maximum Loss: Maxim Loss in the case of Covered Strangle Options Trading Strategy is realized if the stock price falls below the lower strike price at the time of expiration. In this case, the maximum loss will be (500+450)- (15+10)x100 = 92,500
When and how to use Covered Strangle Options Trading Strategy
The Covered Strangle Options Trading Strategy is a bullish strategy used by investors if they think that the stock price will climb higher soon. It can also be used to hedge against any downside risk. If as an investor, you are ready to sell the stocks on profits but are also willing to buy new stocks of the same company if the price falls, the Covered Strangle Options Trading Strategy can be executed for hefty returns.
Pros and Cons of the Covered Strangle Options Trading Strategy
No strategy is without its advantages and disadvantages, the same goes for the Covered Strangle Options Trading Strategy. Although it can allow you to earn profits, there are huge chances of losses which you should understand before implementing the strategy. Here are the advantages and disadvantages of the Covered Strangle Options Trading Strategy:
Investors can profit in the long run through the Covered Strangle Options Trading Strategy as they buy shares at a time when the share price is low.
Due to the long positions in stocks, there are no upside risks as investors are willing to buy more shares of the same company.
Investors are guaranteed good returns in a situation where the market is bullish and the stock prices are climbing every day.
As the options bought are OTM, the Covered Strangle Options Trading Strategy is less affected by the changing volatility than a Covered Straddle Options Strategy.
If the price falls below the lower strike price, the investors can realize huge losses in the Covered Strangle Options Trading Strategy.
The Covered Strangle Options Trading Strategy needs extensive knowledge of options trading to successfully implement and avoid huge losses.
There is always the risk of early assignment where the buyer can exercise the right to buy forcing you to sell before the expiry.
If you believe that the market is bullish and can climb higher, the Covered Strangle Options Trading Strategy is one of the most effective strategies you can use. However, as the loss potential is higher, it is advised to consult a financial advisor such as IIFL before you implement such a complex trade as the Covered Strangle Options Strategy. With IIFL’s tools, charts, analysis, and research, you can build a diverse portfolio and enjoy satisfying returns by investing across a wide range of options.