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A covered straddle is a bullish strategy that consists of a long straddle purchase alongside ownership of 100 shares of the underlying.
As such, only the call is “covered,” making for a limited profit, unlimited risk profile for the trade.
How Is It Composed?
Traders sell one at-the-money call and one at-the-money put, both with the same expiration and strike, and buy 100 shares of the underlying, if it’s not already owned.
Looked at another way, the covered straddle is simply a covered call with an additional short (naked) put appended. And as a naked put has the same profit/loss profile as a covered call, the covered straddle is equivalent to two covered calls, subject to twice the profits if the stock moves higher, and twice the losses if it falls steeply.
Let’s have a look now at a real trading example to better understand the strategy.
This is a chart of Bed Bath & Beyond (NASDAQ: BBBY), a company whose stock you purchased in April for $61 a share and which is today trading for that same $61 (red circle, below):
You’re confident that over time you’ll see a good return, but in the meantime, with the stock just drifting, you turn to your broker to ask if there’s some legal means of making money off the stock.
He assures you that, yes, there is, and suggests a covered straddle. It’s a trade with associated risks, but as you’re both bullish on the stock, they seem negligible for the moment.
Getting It On
It’s June 20 when you step up to the plate and sell the October 61 strike call and October 61 strike put. The first nets you $5.25; the second, $5. You now have a $10.25 cushion should the stock begin to fall.
And fall it does! Just days after you initiate, the stock gaps down as low as $55 before reversing higher, to end near the day’s highs.
You’re on the phone to your broker and going ballistic. How could he let you jump on a losing strategy? Get rid of the position, you tell him.
Not so fast, says your broker, reassuring you that the downside protection you have from the premium has you covered, and the turn in the stock’s fortunes on the day actually appear to him a bullish sign.
And indeed, he’s right. That one-day crash in late June ends up being the low for the year, and the stock climbs steadily until expiration, closing at exactly $54.
Your shares are called away at $61 and the short put expires worthless, leaving you with a profit of $1,025 (your initial premium).
You’re pleased, because the stock would have had to climb to $71.25 ($61 + $10.25) for you to achieve the same profit.
Gains and Losses
Maximum profit on a covered straddle is achieved when the stock expires at or above the strike price of the straddle. It’s equal to the strike price of the straddle, less the purchase price of the stock, plus the net premium earned.
Maximum loss, as mentioned above, is theoretically unlimited, and begins to accrue when the underlying drops to a level at which the premium collected on the trade is lost. That can be determined exactly by using the following formula:
- (The purchase price of the stock + the strike of the straddle – the net premium earned) / 2
In our case above, that’s $55.87 ([$61 + $61 – $10.25]/2), a point safely below the eventual closing price of the stock on the worst day of the year (brown arrow).
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