Covered Straddle 

Options trading offers strategies that cater to different market conditions and investor risk appetites. One such strategy is the covered straddle, which combines stock ownership with options writing. This approach can generate additional income but also carries significant risks. This guide will explain what a covered straddle is, how it works, its risks and rewards, comparisons with alternative strategies, and real-world examples to help beginners understand this trading technique. 

What is a Covered Straddle? 

A covered straddle is an options trading strategy where an investor: 

• Owns the underlying stock 

• Sells (writes) both a call and a put option with the same strike price and expiration date 

This strategy is considered “covered” because the investor owns the stock, which provides partial protection against the short call option. However, the short put option remains uncovered, posing potential risks if the stock price declines significantly. 

Key Features of a Covered Straddle: 

• The investor collects option premiums upfront. 

• The strategy is best suited for a low-volatility market. 

• The risk is limited on the upside but substantial on the downside. 

• The maximum profit is the total premium collected. 

This approach is primarily used by investors who expect minimal price movement in the stock and aim to generate income from the premiums collected on selling options. 

Understanding the Covered Straddle Strategy

How It Works: 

1. The investor owns shares of a stock.
2. They sell both a call and a put option at the same strike price.
3. They collect premiums from selling both options.

At expiration, three scenarios can occur: 

• If the stock price remains close to the strike price: Both options expire worthless, and the investor keeps the premiums as profit. 

• If the stock price rises above the strike price: The call option is exercised, requiring the investor to sell their shares. 

• If the stock price falls below the strike price: The put option is exercised, obligating the investor to buy more shares, potentially leading to significant losses. 

Example Setup: 

• Stock Price: US$100 

• Strike Price: US$100 

• Call Option Premium: US$3 

• Put Option Premium: US$2 

• Total Premium Collected: US$5 per share 

If the investor holds 100 shares, the total premium collected = US$500 (US$5 × 100 shares). 

Risk and Reward Analysis 

Rewards: 

• Premium Income: The investor collects premiums from selling the options, providing immediate income. 

• Potential Profit if the Stock is Stable: If the stock price remains near the strike price, both options expire worthless, and the investor keeps the premium as profit. 

Risks: 

• Uncovered Put Risk: Investors must buy additional shares if the stock price drops significantly, leading to unlimited downside risk. 

• Limited Profit Potential: The maximum profit is capped at the total premium collected, even if the stock price rises. 

• Stock Assignment Risk: If the put option is exercised, the investor must purchase additional shares at the strike price, even if the market price is much lower. 

Breakeven Points: 

• Upside Breakeven: Strike Price + Total Premium Collected 

• Downside Breakeven: Strike Price – Total Premium Collected 

Example Calculation: 

If the stock price is US$100 and the total premium collected is US$5: 

• Upside Breakeven = US$100 + US$5 = US$105 

• Downside Breakeven = US$100 – US$5 = US$95 

The investor starts losing money if the stock price falls below US$95. 

Comparisons and Alternative Strategies 

How Covered Straddle Differs from Traditional Straddle: 

A traditional straddle involves buying both a call and put option, betting on volatility. The covered straddle, however, consists in selling both options while owning the stock, making it a more income-focused strategy. 

Example of a Covered Straddle 

Scenario: 

An investor owns 100 shares of XYZ Corp., currently trading at US$100 per share. They believe the stock will stay near US$100 over the next month. 

Position Setup: 

• Sell a Call Option (Strike Price US$100) → Collects US$3 per share 

• Sell a Put Option (Strike Price US$100) → Collects US$2 per share 

• Total Premium Collected = US$5 per share (US$500 for 100 shares) 

Possible Outcomes: 

• Stock Price Remains at US$100: 

• Both options expire worthless, and the investor keeps the US$500 premium as profit. 

Stock Price Rises to US$105: 

• The call option is exercised. 

• The investor sells their shares at $100. 

• Their effective sale price = $105 ($100 + $5 premium collected). 

Stock Price Falls to US$90: 

• The put option is exercised. 

• The investor buys additional shares at $100, even though the market price is US$90. 

• Their effective purchase price = US$95 (US$100 – US$5 premium collected). 

This example highlights how profits are capped while losses can be significant if the stock price falls. 

Frequently Asked Questions