Trade Management in the Covered Strangle Strategy

Trade Management in the Covered Strangle Strategy

As you may already know, the covered strangle strategy also called the option wheel strategy is based on selling cash-secured puts and if assigned further selling covered calls. In this article we will discuss the main principles of managing the covered strangle options strategy depending on the underlying asset movements over the time.

Here we get into trade management and I tend to think of trading in terms of market development. You need to think about the market going in three ways: it goes either up, down or sideways.

Therefore, you need to have a plan of action knowing what you are going to do in whichever of those three directions the underlying stock price is going to go.

Of course, you may be correct when saying that the market is bullish over the next quarter or six months, but in the next 30 days before your short position expires (usually covered strangles starts with selling cash-secured puts), you likely have no idea whether it is going up, down or sideways.

So, you need to know what you are going to do.

Contents

Trade Management If Start with a Cash-Secured Put

If you are going to start with a cash-secured put as the first step, theoretically at least you would prefer to open your position after a pullback, because after a pullback the stock or index is more likely to be going up.

If the pullback is what you believe to take place in a bearish market obviously, you are not going to enter a bullish trade, but if it is the normal pullback, it would be the ideal time.

Let us figure out what we should do with our trades depending on the market direction:

  • Scenario 1. Trade goes your way.
    Once you have sold this put, if the stock price goes up, then your put just closes at $0.05 out and either you can end the trade, because you do not want to trade this particular stock anymore, or you roll it out to the next month and you simply use the key criteria for this and you keep doing it month after month and collecting your credits.
  • Scenario 2. Trade goes against you.
    Then you are will get the stock at the put strike price. So you have a hundred shares and this point is where we open the strangle. We are going to sell a covered call, we are going to sell a put, and we are calling it a covered strangle.

Now your cost basis is your purchase price less the three credits that you have now received.

Cost basis: purchase price – original CSP credit(s) – CS CSP credit – CS CC credit.

Trade Management with a Covered Strangle

Scenario 1. The stock goes sideways, that is to say it stays between the strike prices:

  • You can choose to let the two shorts expire if you are gutsy enough, or alternatively you can get rid of them when they get down to four or five days before expiration. I do not see any reason to leave them on. However, you can hopefully close both options at $0.05 and sell the underlying asset and thus exit.
  • On the other hand, you may want to roll and stay in this trade. So, you are going to roll both options to the next month. You are going to get two more credits by selling two new covered calls and that fortunately keeps reducing your cost basis. When it goes sideways, it is really the easiest way to trade, because you are collecting two more credits every month and you keep pulling in your credits, and if you got a dividend paying stock, you are pulling in your dividends and it is very simple and good for you. It is not the most return you can get, because the most return is if the stock is going up.

Scenario 2. Trade goes up to above the call strike.

  • Trade ends:
    • Your stock gets called away at the call strike
    • CSP closes at $0.05 or let expire. This is one time when I might not close my put but I might let it expire because if the stock has gone so high that it is going to get called away, then there really is no gamma risk, so I might let this one expire.
    • Now you have no stock and now you would simply start all over again with another cash-secured put
  • Trade continues:
    • But if you do not want the trade to end, if you want it to continue, then you are going to need to roll your call out to the next month and you are going to need to roll or start another cash-secured put because you are going to continue your strangle out into the next month.
      So, it really depends on whether you want to end the trade when the stock price goes up for whatever reason or, normally, you would want to go with it following the rule ‘the trend is your friend’. If it is going up normally, you are going to want to keep going with it.

Scenario 3. The trade goes against you to below the put strike.

At this point you get the stock at the put strike price (the another hundred of shares), so now you have got 200 shares.

When it goes down again you have two choices:

  • either you are worried that it is going down for a reason, so you want to get out of this trade
  • or you still think it is a basic normal pullback and you want to stay in it

If you are ready to exit:

  • You are going to sell two covered calls close to at-the-money (whether you are at-the-money a strike above or at-the-money a strike below). And so that you get the biggest credit and it is going to help you get called away

Alternatively, you may want to continue the trade with your 200 shares:

  • You are going to move your covered calls higher than that out to the next month using the key entry criteria. Given the fact, you have had two stock purchases, your stock purchase price is the average of the two purchases. In addition, at this point your cost basis can be calculated as the average price of two stock purchases minus all the CC and CSP credits plus roll debits.

Potential Market Exits

My next point here is about exits, it is like with a covered call or anything else when at some point you may want to get out of the trade:

  • either the trend and the stock price is broken. It can be due to the price level breakout, or stock price moves out of channel, etc.
  • the underlying ticker has moved below a predetermined stop loss, trailing stop loss, percentage loss, etc.
  • it is always a question with covered calls whether you want to be in the trade over earnings announcements or not. Personally they drive me crazy since an earnings announcement or some bad announcement about the company causes me to lose, but it is not a rational financial decision, it is aggravating. So, I find not trading individual stocks over earnings to be less aggravating, but again that is a personal choice.

Greeks in the Covered Strangle

Let us consider from the greeks viewpoint what is beneficial to us and what is not:

  • Delta: positive delta is good but is not actively managed
  • Theta: works for you, but is not actively managed
  • Gamma: minimize gamma risk and do not let the shorts get within 4-10 days of expiration unless you want to be exercised
  • Vega: when the market is going up, volatility is usually coming down. A market uptrend is good for your underlying stock and it reduces vega which is good for your shorts, but it is also not actively managed.

Conclusions on the Trade Management When Running the Option Wheel

Understanding what actions you should undertake depending on changes in the market situation is critical to the success of the covered strangle performance. This strategy involves a wide variety of tools for options position management and the skillful use of them can improve the final result for a trader. You should be ready for any market development and always know what to do when the market goes in your direction, stays sideways or goes against you.

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