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A reverse covered straddle is a bearish strategy that generates income from a short stock position. It’s composed of a long straddle coupled with 100 shares short in the underlying.
Specifically, the trader sells one at-the-money call and one at-the-money put and shorts 100 shares of stock (if he isn’t already short).
Only the short put is covered, however. Should the stock rise in price, both the short sale and the short call will begin to lose money. The trade is therefore a limited profit, unlimited loss proposition.
Take a look below at a genuine trading example to better appreciate the advantages and disadvantages of the reverse covered straddle.
This is a chart of airborne spyware maker L-3 Communications Holdings (NYSE: LLL):
You shorted L-3 some months ago at $120, but the stock has done little more than trade in a range since then. By the time June rolls around, you’re getting antsy. You want to make some money, but the stock is not cooperating. Your broker suggests you use the existing short position to generate some income. He recommends a reverse covered straddle, a bearish strategy that has limited upside but that could see you through this meandering phase quite nicely.
You decide to jump on it. On June 5 (red circle), you sell the September 115 call and the September 115 put – the former for $6.50, the latter for $6, for a total credit of $12.50.
And the ride begins!
The stock begins swerving and careening higher and lower and by the end of July has topped $124 (black arrow). You’re in a panic, because your short is underwater by $4, and the short call is drowning to the tune of $9! That’s a $1,300 loss that you have no interest in!
And then you remember: You took in $1,250 on the initial sale of the options, so your current paper loss is a mere $50.
Phew.
Fortunately, that’s as bad as it gets. The following day the stock craters, gapping to below $115 and continuing lower through expiration, when it closes at $108 (in blue).
Your short call expires worthless, but your short put is in the money, meaning you bought the shares (and, in so doing, closed out your short position) at $115.
Your profit on the trade, therefore is $1,750 ([$120 – $115 + $12.50] x 100).
Maximum Gains and Losses
Maximum profit on a reverse covered straddle is achieved when the stock expires at or below the strike price of the straddle. It’s equal to the sale price of the short, less the strike price of the straddle, plus the net premium earned.
Maximum loss, as mentioned above, is unlimited, and begins to accrue when the underlying rises to a level at which the premium collected on the trade is lost. That can be determined exactly by using the following formula:
- ([Sale price of the short + the strike of the straddle + the net premium earned]/2)
In our case above, that’s $123.75 ([$120 + $115 + 12.50]/2), a point almost exactly in line with the late July highs (black arrow).
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