What is a 'Covered Straddle'

A covered straddle is an option strategy that seeks to profit from bullish price movements by writing puts and calls on a stock that is owned by the investor. In a covered straddle the investor is short on an equal number of both call and put options which have the same strike price and expiration.

BREAKING DOWN 'Covered Straddle'

A covered straddle is a strategy that can be used to potentially profit for bullish price expectations on an underlying security. Covered straddles can typically be easily constructed on stocks trading with high volume. A covered straddle also involves standard call and put options which trade on public market exchanges.

Institutional and retail investors can construct covered call strategies to seek out potential profits from option contracts. Any investor seeking to trade in derivatives will need to have the necessary permissions through a margin trading, options platform.

Covered Straddle Construction

As in any covered strategy, the covered straddle strategy involves the ownership of an underlying security for which options are being traded. In this case, the strategy is only partially covered.

Since most option contracts trade in 100 share lots, the investor typically needs to have at least 100 shares of the underlying to begin this strategy. In some cases, they may already own the shares. If the shares are not owned the investor buys them in the open market. Investors could have 200 shares for a fully covered strategy, but it is not expected that both contracts be in the money at the same time.

Step one: Own 100 shares with an at the money value of $100 per share.

To construct the straddle the investor writes both calls and puts with at the money strike prices and the same expiration. This strategy will have a net credit since it involves two initial short sales.

Step two: Sell XYZ 100 call at $3.25 Sell XYZ 100 put at $3.15

The net credit is $6.40. If the stock makes no move, then the credit will be $6.40. For every $1 gain from the strike the call position has a -$1 loss and the put position gains $1 which equals $0. Thus, the strategy has a maximum profit of $6.40.

This position has high risk of loss if the stock price falls. For every $1 decrease, the put position and call position each have a loss of $1 for a total loss of $2. Thus, the strategy begins to have a net loss when the price reaches $100 – ($6.40/2) = $96.80.

Covered Straddle Considerations

The covered straddle strategy is not a fully "covered" one, since only the call option position is covered. The short put position is "naked", or uncovered, which means that if assigned, it would require the option writer to buy the stock at the strike price in order to complete the transaction. However, it is not likely that both positions would be assigned.

While gains with the covered straddle strategy are limited, large losses can result if the underlying stock tumbles to levels well below the strike price at option expiration. If the stock does not move much between the date that the positions are entered and expiration, the investor collects the premiums and realizes a small gain.

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