Trading Covered Strangles - Overview

Preamble

It is time to start talking about option trades. I don't plan to do a complete option education. There are plenty of sites that can do that. A good broker also provides free classes to their clients.

I will only provide explanations as to the option trades I use.
I trade trade covered calls and short puts. If this is combined on the same ticker, it is called a covered strangle.
Now in order to trade options the broker needs to give you permissions to trade options. There are different levels of option trading clearance. The level the broker will give you depends on your experience, your knowledge and the amount of liquid funds you have. A good broker asks a few questions to make sure you understand the risks. 

Breaking it down

For a covered call one has to own 100 shares and then one sells a call against it. When selling a call, the seller assumes the obligation to hand over the shares to the agreed price in the call within the period of the duration of the contract + 1 day. An example (all numbers are made up). I buy 100 shares for 50$ each and invest $5,000. I then sell a call for 30 days from now from somebody to get my shares for 52$. I receive 1$ for for it. What does that mean?
From the time of selling to the expiration date +1 day, the other side has the right to call the stock away from you any time they see fit. 

There are 2 scenario's:

• if the stock trades at 51$ it does not make sense for the other side to pay me 52$/share when they can buy it at the open market for 51$/share. However I get to keep the 1$.
• if the stock trades at 53$, the other side can buy the shares from me for 52$/share and they get a discount. Now, I still make money. I bought the shares for $50, sell them for $52 and I get to keep the 1$ from the contract. So I made a profit of 3$/share in 30 days.

There must be a drawback. Yes, there is. If  the stock drops like a rock and trades at 45$ at expiration. The 1$ credit from selling the call by far does not cover the 5$ loss per share. So there needs to be a plan and that has to include taking a loss.

In the short put portion as a standalone position: I am selling a put assuming  the obligation to buy 100 shares for the predefined price within a period of time specified in the contract + 1 day to the price specified in the contract. 

An example (all numbers are made up). The stock trades at 50$, I sell a put contract at 48$ 30 days out. I receive 1$ for this. 
From the time of selling to the expiration date +1 day, the other side has the right to sell the stock to me any time they see fit. 

There are 2 scenario's:

• if the stock at expiration trades at $49, it makes no sense to sell it to me for 48$. They get more on the open market. But I get to keep the 1$.
• If the stock at expiration trades at 47$, I have to buy the stock from the other party at 48$. I basically overpay. Now keep in mind I already got 1$ for the contract. So the break even is at 47$.

Here as well the drawback is when the stock drops like a rock and at expiration trades at 37$. So again, there needs to be a plan and that has to include taking a loss.

Summary:

Being short an option creates an obligation, that I have to full fill for as long as I have the short contract.  

Trading CST's in Margin vs Retirement Accounts/Cash Accounts

I trade this in margin accounts. In an retirement account short puts are cash secured. That means, if I sell a put for $50 then  $5,000 are held "hostage" to make sure one has the cash to pay for the 100 shares that are going to show up. Now there are way's to mitigate this, but since I don't use them I will not talk about them.