How a Covered Strangle Can Greatly Enhance Your Return

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Several weeks ago, I wrote 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.

But hey, we all see ourselves as risk managers first and traders second, right? So, short strangles are well within our wheelhouse.

Placing trades is easy; it’s knowing when to hold ’em and fold ’em that separates traders/investors that fall on their face from those that continually trend their accounts higher over the long-term.

But I digress.

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.

covered strangle, 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 works.

Apple (AAPL) – Covered Strangle

I’m going to keep it simple by using tech behemoth Apple (AAPL) for our covered strangle example.

With AAPL trading for 153.06, we are going to buy 100 shares for $15,306.

Apple AAPL stock chart August

Once we’ve purchased at least 100 shares we then will sell a delta neutral short strangle around the shares. Since AAPL is trading for roughly 153, 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. Moreover, I will look to go out 20 to 50 days. My preference is to go with a shorter duration for my short strangle, but the amount of premium I can bring in will define my choice of expiration cycle.

Here are our choices for expiration cycles. I’m going to use the October 15, 2021 expiration cycle with 46 days left until expiration.

Screen Shot at PM

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.

On the call side:

AAPL calls october expiration cycle

We can sell the 165 call strike for roughly $1.26. The 165 call strike has a probability of success of 83.16%, or a delta of 0.19.

AAPL puts options expiration cyckle

We can sell the 165 call strike for roughly $1.26. The 165 call strike has a probability of success of 83.16%, or a delta of 0.19.

On the put side:

We can sell the 135 put strike for roughly $0.80. The 135 put strike has a probability of success of 87.76%, or a delta of 0.10.

The Trade

Simultaneously:

  • Sell out-of-the-money call
  • Sell out-of-the-money put

Sell to open AAPL October 15, 2021 165 call

Sell to open AAPL October 15, 2021 135 call for a total credit of $2.06

Premium Return: $2.06 ($1.26 for the call + $0.80 for the put)

Breakeven Price: 151.00

Maximum Profit Potential: $1,400 ($165 short call strike – $151.00 breakeven)*100

A Few Possible Outcomes

Stock Pushes Above Short Call Strike

If Apple pushes above the 165 short call strike, no worries, we get to keep the put premium of $0.80, the call premium of $1.26 and we make roughly $12 on the stock. Overall our gain would be $1,400, or 9.15% over 46 days.

Stock Stays Within the Range of 135 to 165

If Apple stays between our short put and short call we get to keep the entire premium of $2.06, or 1.35% over 46 days. We can use the covered strangle strategy roughly seven more times over the course of the year for a total annual return (just premium) of approximately 10.8%.

Stock Pushes Below our Short Put Strike

If Apple pushes below our short put strike of 135 we still get to keep our overall premium of $2.06. But we would be issued 100 shares of stock for every put sold. Our breakeven on the newly issued shares would be $132.96, a discount of 13.13%.

To sum up a covered strangle options strategy, if you wish to enhance a stock position, like AAPL, 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.