February 28, 2013
- Managing Director, Institutional Trading and Fixed Income, TD Ameritrade Institutional
“This post is contributed by Jeff Chiappetta, Institutional Trading and Fixed Income, TD Ameritrade. Jeff and his team work with advisors to help them evaluate and develop options strategies for their clients.”
Options—one of my favorite topics of conversation!
Selling covered calls can be a simple way to differentiate your business and potentially generate income in a low interest rate environment (and some economists may consider this a low rate environment!)
One strategy that can potentially generate income for your clients while generating greater alpha is writing/selling covered calls while simultaneously selling puts on the same underlying security. This position is called a “covered strangle” and it combines the benefits and the risks of a covered call and a short put.
Here’s the formula:
Long stock + short covered call + short put = Covered Strangle
Seems simple, right?
Investors may realize the following benefits from this options strategy:
• Retain dividend rights on the underlying stock owned
• Earn two premiums by selling the calls and puts
• Lower cost basis on the stock
• Use as a rebalancing tool (to enter or exit an equity position)
• Downside protection up to the premium received
Of course, the covered strangle options strategy is not without risks:
• The long stock position could be called away, reducing upside profits
• The downside protection is limited to premium received
• More stock could be put to you (from your short puts) above current market price
• Stock dividend could be lost if short calls assigned (stock is called away)
• Transaction costs
Here’s one way to construct a covered strangle strategy:
1. Selling both a put and call at the same time against the stock owned. (You must own a minimum of 100 shares of the underlying.)
2. The call sold has a strike above the current price of the stock (at a price you’re willing to sell the stock for)
3. The put sold has a strike below the current price of the stock (at a price you’re willing to buy more of the stock)
Here are additional variations of the strategy to consider:
• Sell the call option with a .30 to .40 delta*, or a call with a strike price you’re willing to sell the stock at, or maybe even at a strike just above a technical resistance level.
• Sell put options with -.30 to -.40 delta, or with a strike price you’d be willing to buy the stock at, or at a strike price just below a technical support level.
Once you’ve put the options position on, then what? With expiration approaching, you can scale out of the position(s) by covering (buying back) some of the options, let the positions expire, or get assigned.
What do you think? Seems pretty simple?
Options can be used as a strategy for potentially generating income for your clients while generating even more alpha. The TD Ameritrade Institutional Strategy Desk is available to discuss your options (pun intended) regarding covered strangles and other risk-defined strategies that may be useful to your clients. Call us at 800-934-6124.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades. Investors should also consider contacting a tax advisor regarding the tax treatment applicable to multiple-leg transactions.
Maximum Gain: the call and put premiums received, less transaction costs.
Maximum Risk: since one leg of a short straddle is a naked call, the risk is unlimited.
Past performance of a security or strategy does not guarantee future results or success. Content is provided for illustrative and educational use only and is not a recommendation or solicitation to purchase any specific security or utilize a specific strategy.
Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any trade. Please use your particular cost information, including commission, contract fees, and exercise and assignment fees, when evaluating any trade.
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
*The measure of an option’s sensitivity to changes in the price of the underlying asset.