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Reducing Cost Basis with Covered Strangles

Continuing the cost basis reduction series, today I’m talking about covered strangles. A covered strangle combines two of my favorite options trades into one. You sell call and you sell a put around your shares. Next week I'll take the CAH example where I sold the covered calls and show you how a covered strangle would have been even more profitable!






Risk:


A covered strangle doubles the premium since you are selling a call and a put! Please realize that when you increase the reward you are also increasing your risk.  More premium, more risk—that's the stock market's mantra! So, before you decide if a covered strangle is a good strategy or ‘right’ for you let’s talk about the risk and discuss what I like about covered strangles.


I wrote about how the covered call’s only "risk" is capping your upside. That still is true with a covered strangle. The good thing is the stock price can’t be at two different strikes at expiration so the short put you sold would be worthless so if you were called away your premium collected would be a little more with the short call.


The bigger risk with a covered strangle is on the put side of the trade. Just like selling a naked but you are agreeing to purchase more shares if your short put expires in the money. We all know that a stock can go to zero, its not likely but it’s possible and so you need to account for this.


Mechanics:


I generally sell a 20 or 30 Delta Strangle. I use the same rules I use for covered calls and puts in terms of looking at the chart for support and resistance. This is a great way for me to not only reduce my cost basis, but also dollar cost average! If I am assigned more shares from the put I will be ‘forced’ to buy low.


I will sell options in the monthly expiration closest to 30 to 45 days to expiration. Is there support and resistance at these strikes? Usually there is! Is there enough premium at these strikes? Sometimes you have to bend your roles a little bit because you may not get as much premium as you want, but remember you are getting a dividend as well!


You can also think about how we trade strangles using math-based principles. Math based traders normally sell strangles in high volatility environments and collect the premium without owning shares. So this strategy is similar to that except for you still have shares. If you see a lot of volatility or you don’t mind owning more shares consider a strangle instead of just a covered call!


Trade Plan:


As with any options trade the premium needs to justify the risk you are taking. In terms of your trading plan you have to determine how to manage a strangle. If you can’t don’t want more shares perhaps you consider a rule to close the strangle at 200% of the premium received. Make a plan for when the stock goes up, down or sideways!


If the stock goes above my covered call I roll as long as I can for credits then I let the shares go.


If a stock trades sideways this is great! I keep selling strangles over and over again reducing my cost basis. OR I close the trade and take my profits to buy something tangable.


If the stock drops, my rule is to keep rolling the short put as it is tested. Meaning as the price touches my stirke I keep rolling for hope. I keep collecting credits closing my current put and selling a put further out in time and away from the money if possible. Remember you get paid for time. I'll do this until I am assigned shares or the stock bounces and my GTC order hits target. This does require buying power as you are agreeing to purchase another 100 shares for each put you sell.


You should create rules that make sense for your plan and your account.  For example, if IVR of the stock is high, maybe you sell a strangle instead of a covered call, assuming your account can handle another 100 shares of the underlying. Everyone says they want to buy low and sell high, a strangle helps you do just that on a smaller timeframe. The put is forcing you to purchase more shares, the covered call will sell your shares higher.



Advanced stategies


For the more advanced and active traders you can also leg into a covered strangle. I previously discussed waiting for multiple up days or for the stock to reach resistance to sell a call. You can follow this rule, and also wait for some down days or the stock to reach support to sell a put. You do collect more premium doing this but there are some down sides as well first of all you have to actively be watching or monitoring the stock through alerts. But sometimes you don’t get the move you need to sell the option. If the stock traded sideways a 30 Delta strangle is going to give you the theta decay you wanted. You would never have a chance to leg into the strangle so you missed out on that premium. That’s just a tradeoff of waiting for more premium. Ultimately the choice is yours.


You can also sell 2 puts instead of just 1, but this obviously increases your risk and obligation to buy more shares. It is something I do not do very often unless i have a strong conviction on the stock or I want more shares.



Conclusion:


 

I do like selling strangles against my shares because it doubles the premium I receive. It also increases my risk so I make sure I have a plan and understand what could happen if the stock were to drop significantly. I know how to hedge my shares using long puts if necessary. Keep in mind no strategy is ever going to work all the time you will have to manage some losers so it’s important to have a plan. I will say this strategy has been successful for me throughout the years. After all it is combining two of my most favorite options trades. The covered call and the naked put. When one of the option’s strike price is being challenged the other strike is winning. So you are reducing some of your loss. By understanding your biggest risk is to the downside, and if you are buying at a support zone a covered strangle make a lot of sense. This is an amazing way to reduce your cost basis quicker than just selling calls.


After the CAH example of a covered strangle I will discuss a collar and a super collar. Both of these can reduce your cost basis, but they also are a nice way to hedge your position as well. We’ll jump into all the details next time. Happy Trading Good Kids!


Disclaimer: this is NOT financial advice. I’m basically just some dude on the internet who’s been trading a while, and I use the stock market as my primary source of income. None of this is financial advice it’s purely educational!

 

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