Custom «Option Strategy: Covered Straddle» Essay Paper Sample

Option strategy involves purchase or sale of one or more option positions including an underlying position. Option strategies are able to favor underlying movements that are bearish, bullish or even neutral (McMillan 54-112). Neutral strategies are further divided into those that are bearish on volatility and those that are bullish on volatility. Bullish option strategies are often applied when the seller predicts that the underlying stock price will move upwards. It is therefore necessary to access and determine the level at which the stock price can reach and the limited time within which the rally will take place so as to pick out the optimum trading strategy.

The most common bullish of options strategy simple call buying which is applied by majority novice options sellers. Stocks rarely rise up to large scales, therefore bullish option sellers moderately come up with a specific price for bull run while using the bull spreads to minimize costs though this does not reduce risk due to the fact that the options will still expire. In these strategies, maximum profit is limited and as a result they cost minimal amount to employ over a given nominal cost of exposure. Examples of moderate bullish strategies include the bull put spread and the bull call spread. Mildly bullish options strategies will continue making money so long as the underlying stock price does shift downwards with the option's date of expiration. Such strategies only provide minimal downside protection. An example of these option strategies is writing out of the money covered calls. Below is a diagram elaborating further on writing out of money calls

As shown below the moderate bullish investor is selling out of the money calls contrary to the underlying shares. In this strategy the trader continues collecting profit while enjoying capital gains if the underlying stock rallies. 

Bearish strategies are the direct image of bullish strategies. They are applied when the options buyer predicts that the underlying stock price will shift downwards (www.theoptionsguide.com). Therefore, it is necessary for the trader to access the extent to which the stock price can be low and the time limit within which the decline is bound to take place so as to appropriately pick out the optimum trading strategy. The most common trading options of bearish strategies are the simple buying strategy which is used by most novice options sellers (McMillan 54-112). Stock prices will at occasional times shift steeply downwards. Bearish option sellers will moderately select a particular price for the predicted decline and make use of bear spreads to minimize costs. In this strategy, maximum profit is expected as they usually cost little to apply. Examples of this strategies include the bear put spread and the bear cal spread. Mildly bearish selling option strategies make money so long as the underlying stock price does not shift up with regard to options expiry dates.

Neutral strategies in option trading are applied when the options seller is not in a position to predict whether the underlying stock price will shift upwards or downwards (www.theoptionsguide.com). The potential profit in this strategy does not rely on the shifting of underlying stock price, but it rather relies on the predicted volatility of the underlying stock price. This is the reason why this strategy is referred to as non-directional strategy. Examples of neutral strategies include risk reversal, butterfly, straddle, strangle and gut strategies.

Gut involves selling in the money put and call whereas butterfly buying in the money and out of the money call, selling of two at the money calls and vice versa (McMillan 54-112). Straddle involves taking a position in a put and a call with the strike price and expiration remaining constant. If the options are sold the holder attains a short straddle and if they were bought the holder attains a ling straddle (McMillan 54-112). Long straddle is only beneficial when the underlying stock shifts value in a significant way, either upwards or downwards. The short straddle is only when there is no substantial shift. Strangle strategy involves simultaneous selling or buying of out of the money call and out of the money put with similar expirations but differing strike prices.

Neutral selling strategies that are bullish on volatility gain when the underlying stock price remarkably shifts downwards or upwards. They include the short butterfly, short condor, long strangle and long straddle. Neutral trading strategies that are bases on bearish on volatility gain when the underlying stock price undergoes minimal movement or is constant. Examples of such strategies include long condor, long butterfly, ratio spreads, short strangle and short straddle.

The option positions applied can be short or long positions in calls or puts at different strikes. The covered straddle is a form of bullish strategy in options trading which engages simultaneous selling of same number calls and puts of a similar striking price, underlying stock and expiration date while possessing the underlying stock. Only call options remain covered.

Covered straddles are constructed of long 100 shares, sell one ATM CALL and Sell one ATM put. They have limited profits with unlimited risk of option strategies which resemble writing of covered calls. Therefore, the covered straddle has a combination of both naked put write and covered call write (www.theoptionsguide.com). A covered stride can also be regarded as an equivalent of two covered calls because the naked put write consist of a reward profile of a covered call. Below is a covered straddle payoff structure.

The covered straddle has limited potential profit. Maximum profit is achieved when the underlying stock price on expiration date is going above the strike price of the sold options or when the underlying stock price is trading at the strike price of the sold options. Maximum profit is calculated using the formula below.

(Strike price of short call-Underlying Purchase Price)+ Net Premium Received- Commissions Paid out= Maximum Profit.

Maximum profit is attained when the price of underlying is greater or equal to the price of the short call (McMillan 54-112).

Unlimited Risk

When writing a covered straddle, increased losses can be experienced. When the underlying stock price makes moves downwards below the breakeven point at expiration loss is experienced. At this point, the covered straddle looses both the naked put and the long stock position. The formula used in calculating this loss is as follows:

Maximum Loss is Unlimited

Loss results when the Price of Underlying is less (Underlying Purchase Price + Short Put of Strike Price - Net Premium Received) /2

Therefore Loss = Purchase Price of Underlying + Short put Strike Price - (2 x Price of Underlying ) - Maximum Profit + Commission Paid

Source: www.theoptionsguide.com

Breakeven Points

The breakeven point is attained at the underlying position for the covered straddle which is calculated as follows.

(Purchase Price of Underlying + Strike Price of Short Put- Net Premium Received) /2 = Breakeven point (www.theoptionsguide.com)

Commissions

Commissions can utilize a large portion of active traders' profits therefore it is wise enough for them to look after low commissions brokers.