First Steps to Start the Covered Strangle
- Principles for selecting stocks for the covered strangle strategy
- The choice of options parameters for the covered strangle
- Conclusions on the main steps of running the covered strangle
Principles for Selecting Stocks for the Covered Strangle Strategy
In this article we will discuss the first steps every option trader should do to correctly start the covered strangle options strategy. As you may know from our previous articles, the covered strangle or the option wheel strategy is a bullish or neutral to bullish strategy that is formed by selling cash-secured puts and if assigned further selling covered calls.
Selecting stocks is one of the most important steps in running the covered strangle strategy. Let us figure out what stocks are better to choose to effectively run this options strategy.
Below are some insights for stock selection:
- In terms of just the usual stock selection, since this is a bullish trade, you really want to get into something that you believe is going to go up. Moreover, there are many different ways to decide when you believe a stock is going to be bullish. Everybody has their own ways of deciding about bullish stocks.However, for me the stock is trending up means it is above the last support level on the Daily timeframe and the last broken level is resistance. Apart from this, someone can put attention to the following points in determining the upward movement: on the weekly chart the 10 EMA is above the 40 EMA, or on the Daily chart 5 EMA is higher 13 EMA, stock is in a long-term channel, etc.
- Somebody would prefer tickers that pay dividends but honestly, growth stocks also can be used, and you do not have to use dividend-paying stocks with covered calls. I prefer to use the following filters:
- stocks > 3% dividend yield
- ETF > 1.5% dividend yield
- indexes > 1% dividend yield
- As with any other trade, it’s always better to use a high-volume liquid penny increment above twenty dollars per share underlying tickers.
So again there is nothing magic about this, you are trying to pick a bullish stock is all you are trying to do.
Sometimes people have a question here – what if a company that we expect to be bullish, starts to decline at some point. Is it possible to hedge that downside with buying a lower out-of-the-money put? In other words, when running the covered strangle you are selling the expensive puts, but on that downside you could take some premium and some people buy a long put here. Is it a productive downside there or not? The reason why they are doing it lies in the fact that the stock markets have been so bullish, if you are doing iron condors or strangles, the call side gets killed so much. Therefore, they have tried to come up with a three-legged strategy that better deals with bullish markets but still has some trade on both sides of the current stock price. Moreover, that is a whole other strategy.
The Choice of Options Parameters for the Covered Strangle
As we agreed upon the stock to trade, we proceed to the next step of covered strangle strategy that includes the choice of options parameters. Let us consider what parameters of options are better to choose.
Below are some insights to option selection:
- Strike selection:
- 8-12% annualized return on the options
- Delta of 25-30
- Near support and resistance levels
The strikes you choose are really what you would choose for a covered call or a cash-secured put, this is not any difference here. So, whether you choose your strikes based on your annualized return from the strike, whether you choose the strike based on delta, whether you choose your strikes based on support and resistance, whether you choose them based on a percentage away from the current stock price, you would do the same thing for this.
- Days till expiration (DTE):
- 30-45 and not over an earnings announcement
- For covered calls, expiration date after ex-dividend date
Then again, some people sell covered calls weekly, some people like to put the call a little farther out. I think the most standard approach is to use DTE around 30 to 45 and most people will say do not do it over an earnings announcement because then you are just gambling. Again, it is no different from what you might do otherwise and for the covered call side of it, I tend to think if we are getting close to a dividend date, I would rather have my expiration date on the other side of the dividend date. So, I’m certain I’m going to collect the dividend rather than having it on the short side and either having it called away before I get the dividend or having to mess around with rolling it before the dividend etc.
- Immediately set a buy to close order at $0.05 for both sides. Once I have a dollar or two credit once it is down to five, ten cents something like that, why would I gamble the dollar or two that I have already made in order to make literally a few more pennies, it just seems ridiculous to me.The more time is left, the more likely I would get out of it. When you get down to the last few days, if you have the strangle on, then, if one side is going to get called away or put to you, you obviously can let the other side, because it’s a mile away just expire worthless and make your extra five dollars. However, if it is going sideways, your gamma can just kill you in those last four or five days. I know some people who like to gamble for pennies on the dollar but I do not see any reason to gamble. Therefore, when it gets close to expiration I close them out or roll them. It is not mandatory but this is my trading plan and so this is the way I do.
- Normally to start with a cash-secured put (CSP) but you could jump into the strangle as your initial trade just as you could jump into a covered call with your initial trade, you don’t have to go through selling a put first, it’s just a personal preference on your part but I will.
Conclusions on the Main Steps of Running the Covered Strangle
Selecting stocks to trade and optimal options parameters of the underlying asset is critical to the success of the option wheel performance. First, you should believe the stock is bullish, options should be liquid enough, but if it is the dividend stock or not, it does not matter, but if it is – it is better for you because if you start owning the stock, you will benefit more in this case. After that, you should choose the appropriate option to trade starting from the strike price selection. I like to think about what is my annualized return but there is nothing wrong with any of the other many different ways for choosing strikes. Options with 30 to 45 DTE and not over an earnings announcement are best for successful performance of the covered strangle strategy.