"Combining Covered Call with Straddle?"

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"Combining Covered Call with Straddle?"

"What are the pros & cons of writing a deep in the money covered call and then using the a proportion of the premium to buy an at the money straddle? If I am already long the underlying stock, this would seem to be a low risk way of protecting both upside opportunity and downside risk, assuming that I let the options run to expiry, get assigned on the DIM covered call and exercise either the put or the call depending on which way the underlying had moved to re-establish the long stock position. Would this work.. or am I missing something?"
Asked By NMus on 19 March 2012

Answered by Mr. OppiE

Hi Nmus,

This is an extremely interesting combination options strategy indeed and I have to be honest with you that in all my years of trading options, this is the first time I actually looked into such a Deep In The Money Covered Call + Long Straddle combination. Honestly, I was surprised at the effects of such a combination myself and found it to be extremely interesting. Here's what I found...

First of all, financing the Long Straddle using proceeds from the Deep In The Money call options written effectively changes the Deep In The Money Covered Call from a neutral / bullish options strategy where you will make a loss only when the price of the underlying drops drastically, to a volatile options strategy where you will make a loss only if the price of the underlying stays relatively stagnant. Below are the risk graphs of both options trading strategies and the resultant options position:

As you can see from the risk graphs above, combining the Deep In The Money Covered Call with the Long Straddle gives you the properties of both options strategies, transforming it into a volatile options strategy where you will make an unlimited profit should the price of the underlying goes upwards and a fixed profit should the price of the underlying goes downwards.

The advantage of such an approach seems to be the fact that you are financing the long straddle using proceeds from the DITM call options sale which allows a simple stock position to be transformed into a volatile position without paying extra money. It appears that such a transformation would be very useful if you are holding a stock you know is going to make a big move soon either to upside or downside and you want to make sure you still make some profit should the stock price tanks. Examples of such volatile situations include earnings release, court verdicts or even FDA approval for new drugs. Lets take a look at what happens in either situation.

Example of Combining Covered Call with Straddle Assuming AAPL is trading at $595 right now with its April $595 strike price call options asking for $25 and its April $595 strike price put options asking for $25 and its April $550 strike price call options bidding for $55. You own 100 shares of AAPL and you are expecting AAPL to make a big move in either direction soon ahead of an important product announcement. You sold 1 contract of its April $550 strike price call options forming a Deep In The Money Covered Call and recieved $5500 in proceeds. You then bought 1 contract of its April $595 call and put options ($25 + $25 x 100 = $5000) using the proceeds forming a straddle. Scenario 1: AAPL rallies to $610 AAPL's product announcement went well and stock price rallies to $610 by expiration of the April options. Profit from shares = $610 - $595 = $15 Loss from $550 strike price call options = $610 - $550 = $60 - $55 = $5 Loss from $595 strike price call options = $610 - $595 = $15 - $25 = $10 Profit from $595 strike price put options = $25 Net profit = ($15 + $25) - ($5 + $10) = $40 - $15 = $25 Scenario 1: AAPL drops to $580 AAPL's product announcement went sour and stock price tanks to $580 by expiration of the April options. Loss from shares = $595 - $580 = $15 Profit from $550 strike price call options = $580 - $550 = $30 - $55 = $25 Profit from $595 strike price call options = $25 Loss from $595 strike price put options = $595 - $580 = $15 - $25 = $10 Net profit = ($25 + $25) - ($15 + $10) = $50 - $25 = $25

As you can see above, having such a position in place not only made sure you continue to profit should the price of the underlying stock rallies but it actually increases its profits! In the example above, you would have made only $15 profit if you had held only AAPL shares instead of $25 profit with this options trading strategy in place. Not to mention the fact that you won't have made that $25 profit if the price of AAPL drops instead of rises. But what is the drawback of this approach? The drawback is that if the price of AAPL remains stagnant, you would have made a loss in the order of the expired long straddle less the extrinsic value of the deep in the money call options.

Maximum Loss Example of Combining Covered Call with Straddle Maximum loss = Maximum loss of straddle - extrinsic value of short DITM call Maximum loss = ($25 + $25) - ($55 - $595 - $550) = $50 - $10 = $40 x 100 = $4000

The overall delta of the position would also be inclined to be positive, as such, the position would tend to make a profit if the price of AAPL goes up and make a loss if the price goes down with significant time left to expiration. Also, the theta of the position is negative. This means that time decay works against the position and the position will lose value over time due to time decay of all three long options legs if the price of the underlying stock remains stagnant. As such, when it is clear that the price of the stock is going to remain stagnant and there is still significant time to expiration, it is advisable for you to close out the long straddle and just hold on to the Deep In The Money Covered Call in order to prevent a loss.




In conclusion, financing a long straddle using proceeds from the Deep In The Money Covered Call is a very clever options trading strateby combination which takes no additional money to put on and transforms a stock position into a volatile position. However, you need to take note of the fact that a loss will occur if the price of the underlying stock remains relatively stagnant, even if you eventually allow your stocks to be assigned.