Introduction:

This is just a short paper outlining how I traded the covered short strangle. This is a great strategy for new traders and for experienced traders as well. I believe every new trader should begin his trading career trading cash-secured puts and covered calls. The combination of those two strategies comprises the “covered short strangle“.

Only after a new trader masters those two strategies, should he think about moving onto more complex trading strategies. Depending on how a trader structures a trade and manages his money, he can be as conservative or as aggressive as he desires.

Watch on Youtube:

Summary

• How to Create a Portfolio of Investments and Expand It.
• Unison Covered Short Strangles.
• Growth option strategy that is conservative.

Why Trade UCSS:

Generating Revenue:

Covered strangles are tools that can be used to generate income. By selling an out-of-the-money call option and a put option simultaneously on a stock that an investor already holds (i.e., it is ‘covered’ by the existing stock), the trader can earn premium income from both options.

If the stock price stays within a particular range (between the call and put option strike prices) until the options’ expiration, both options will expire worthless, allowing the trader to keep the premiums as profits.

Expecting Limited Price Movement:

Traders might choose to use covered strangles when they predict that the underlying stock will stay within a certain price range or exhibit minor price fluctuations within a specified period.

By setting the strike prices of the call and put options outside this expected trading range, the trader may earn profits from time decay as both options decrease in value.

Managing Risk:

Covered strangles can offer a certain degree of risk management. The income from the sale of both the call and put options provides a buffer, which can help to balance out potential losses from the stock position in case the stock price moves unfavourably.

This strategy can help to lessen the risk linked with a notable drop in the stock price or a sharp rise above the call option’s strike price.

Flexibility and Adjustability:

Covered strangles allow for position adjustments. If the stock price starts nearing one of the strike prices, traders have the option to roll or close out their positions. This means they can manage risk and take profits if they wish. This flexibility allows traders to adapt to shifts in market conditions and alter their positions as needed.

Tip: However, it is crucial to remember that trading options, including covered strangles, is risky and requires a deep understanding of options strategies, market behaviours, and risk management tactics. Traders should carefully assess their risk acceptance, carry out detailed analysis, and consider seeking advice from a financial expert before they begin trading options.

What determine its performance?

To construct a portfolio, it is essential to understand the factors that determine its performance. A significant study was conducted and published in the Financial Analyst Journal in 1986, followed by two separate studies in 1991 and 2000. Remarkably, all three studies yielded nearly identical results. These findings often catch traders off guard, surprising them with their consistency.

Determinants of Investment Performance

Asset Allocation – 93.6%

Security Selection – 2.5%

Market Timing – 1.7%

Other Factors – 2.2%

Since asset allocation is most important, where do we begin?

A simple way to build a portfolio of SP500 stocks is to use the Sector SPDR ETF’s. They are 9 select ETF’s broken down into 9 sectors:

• XLY – consumer discretionary (MCD, TGT, NKE)
• XLP – consumer staples (KO, PG, WMT)
• XLE – energy (SLB, CVX, XOM)
• XLF – financials (GS, BAC, JPM)
• XLV – health care (UNH, JNJ, CVS)
• XLI – industrials (GE, UPS, CAT)
• XLB – basic materials (EXP, BHP, AA)
• XLK – technology (IBM, NVDA, AAPL)
• XLU – utility (CMS, NEE,DTE)

Those in parenthesis are just a n example of stocks that we can choose from but no mean recommendation for a particular stock to trade.

So let us start and explore UCSS’s functionality.

Let us imagine you want to establish a portfolio with $100,000 in capital and you have decided to buy 200 shares of Apple. AAPL is currently worth $125.50 per share. You have made the decision to use a UCSS to purchase those shares for less money than they are currently worth.

Effect of Volatility Shifts:

Volatility is a metric that measures the percentage-based fluctuations of a stock price, and it’s a key variable in option pricing. When volatility increases, assuming other factors like stock price and time to expiry remain unchanged, option prices typically rise.

Consequently, short option positions increase in price and incur losses when volatility escalates. Conversely, when volatility diminishes, short option positions earn profits.

Given that a covered strangle involves two short options, the strategy experiences double losses when volatility goes up and double profits when it declines. However, since the options in a covered strangle are out-of-the-money, the impact of volatility shifts is generally less severe compared to a covered straddle.

Effect of Time Passage:

The portion of an option’s total price that represents time value diminishes as the expiration date approaches. This phenomenon, known as time decay, benefits short option positions, assuming all other variables stay constant.

Since a covered strangle has two short options, it profits doubly from the passage of time towards expiration.

However, the options in a covered strangle are out-of-the-money, making the impact of time decay generally more consistent compared to a covered straddle. In contrast, a covered straddle experiences slower time decay initially, which accelerates as

CSS Strategy Payoff Diagram:

UCSS Strategy Trading Flow Chart:

Appropriate market forecast

The covered strangle strategy requires a modestly bullish forecast, because the maximum profit is realized if the stock price is at or above the strike price of the short call at expiration. The Strategy is perfect to apply when ou are bullish on the market and expecting less volatility in the market.

Actions

Buy 100 shares + Sell OTM Call +Sell OTM Put

The covered strangle options strategy can be executed by buying 100 shares of a stock while simultaneously selling an OTM Put and Call of the same the stock and similar expiration date.

Breakeven Point

There are 2 break-even points in the covered strangle strategy. One is the Upper break-even point which is the sum of strike price of the Call option and premium received while the other is the lower break-even point which is the difference strike price of short Put and premium received.

So let us start and explore UCSS’s functionality.

Let us imagine you want to establish a portfolio with $100,000 in capital and you have decided to buy 200 shares of XYZ. XYZ is currently worth $125.50 per share. You have made the decision to use a LCSS to purchase those shares for less money than they are currently worth.

Trade Example:

Step #1. Sell one XYZ, OTM (or ATM/ITM If security is already down a lot) short put contract.

Days to expiration (DTE) = 30

Delta ~ 0.30

Stock Price = 117.50

Strike Price = $112.50

Premium = $1.55

Break Even = $110.95

Maximum profit

Profit potential is limited to the total premiums received of $1.55 per contract or $155.

Maximum risk

Potential loss is substantial and leveraged if the stock price falls below the short put strike price of $112.50 at expiration, losses are $2.00 per share for each $1.00 decline in stock price, because both the long stock and the $112.50 short put lose as the stock price declines

Step Trade Management:

No adjustment are used in this step 1 because you plan to buy XYZ at $112.50 and are selling the puts as part of a process to build your portfolio even if the trade expired ITM which is one of the best outcome anyway.

Your initial 100 Microsoft shares are yours if assigned at $112.50 per share. If you are not assigned, the process is repeated while lowering the cost basis until assignment. You are given a price of $110.95.

Step #2. Your short put contract has been assigned and now own 100 shares. Your cost-basis is current price of $110.95.

Step #3. Sell a covered short strangle.

Trade 1: Short Put: 

Stock Price = 109.50

	Call	Put
Strike Price	$115.50	$105.50
Premium	$1.35	$1.41
Delta	~ 0.30	~ 0.30
DTE	30	30

Net Premium = $(1.55 + 1.35 + 1.41) = $4.31

Cost Basis = $(110.95 – 4.31) = $106.64

Trade 2: Short Call (Covered): To select a strike, I look for a call strike that gives a premium about equal to the short put premium.

You already own 100 shares of XYZ from assignment of step #1.

XYZ = $110.95, (your cost-basis)

	Call	Put
Strike Price	114.25	104.50
Premium	$1.55	$1.52
Delta	~ 0.30	~ 0.30
DTE	30	30

Total premiums = $3.07

Net Premium = $(1.55 + 1.35 + 1.41 + 3.07) = $7.38

Cost Basis = $(110.95 – 7.38) = $103.57

Symbol: XYZ =

First Put Assigned @ $112.50 Strike Price Basis Cost = $11,250;

Second Put Assigned @ $104.50 Strike Price Basis Cost = $10,450

Net Investment (NI) = $21,700

% Return at expiration:

No change in XYZ @ $109.50

Premiums = $307

% ROR = (P/NI)*100 = 1.41%

% AR = (ROR*365/30) = 17.21%

At Short Call Strike $114.25

Capital gains = (Call Strike – Stock Price) = $(114.25 – 109.50) = $475

Premiums = $307

Total = $782

% Return = 3.60%

% AR = 43.84%

Step #3 Results:

1. Call expires and Short Put expires:

Own 100 shares: Sell 1 Call and Sell 1 Put

2. Call assigned and Short Put expires:

All cash: Go back to Step #1

3. Call expires and Put assigned:

Own 200 shares: Sell 2 Calls

4. Call assigned and Put assigned:

Own 100 shares: Sell 1 Call and Sell 1 Put

This is merely a general method for applying CSS. Each trader is free to select their preferred delta, expiration, and adjustment options. The CSS can be set up more for growth, income, or perhaps both. If assigned, you may decide not to keep selling calls and repeating the process once, you have acquired the stocks in your portfolio.

7 key takeaways of the Covered Strangle Strategy:

1. Combination of Covered Call and Short Put

The covered strangle combines a covered call with a short put position. You sell a call against stock you already own and simultaneously sell a put at a lower strike price. This strategy allows you to generate income from both premiums.

2. Moderately Bullish Outlook

This strategy is ideal for traders who have a moderately bullish view on the underlying asset. You expect the stock to rise or stay within a certain range but are willing to buy more shares if the price drops below the put strike.

3. Premium Collection

You collect premiums from selling both the call and the put. These premiums serve as a cushion for potential losses and can improve your overall return if the stock moves sideways or modestly higher.

4. Limited Upside Potential

The upside is limited to the call strike price, plus the collected premiums. If the stock rises above the call strike, the shares will likely be called away, capping your profit at the call strike.

5. Downside Risk

The downside risk occurs if the stock falls below the put strike price. In this case, you may be obligated to purchase additional shares at the lower strike price, which could result in significant losses if the stock continues to decline.

6. Capital Commitment

Since you’re selling a put option, you need to have sufficient capital to buy more shares if assigned. This makes the strategy capital-intensive, especially if the stock price falls and you’re assigned the put option.

7. Ideal in Low-Volatility Markets

The covered strangle strategy works best in low-volatility markets where large price swings are less likely. In such cases, you can collect premiums without much concern for drastic stock price changes.

This strategy combines income generation with moderate risk, making it suitable for traders comfortable with owning more shares of the underlying stock.

Conclusions:

In a covered strangle strategy, the short call position is protected by the long (or owned) stock, but the short put is not technically “covered” as there is no cash held aside like in a cash-secured short put. Instead, in a covered strangle, the account equity, inclusive of the long stock, serves as collateral for the margin requirement of the short put. Therefore, a significant decline in account equity could lead to a margin call. This strategy is suitable only for aggressive investors willing to take on this risk.