September 25, 2021
by Peter Seed
Those of us who trade short puts may have unwittingly executed fully-covered short strangles. Here’s how.
To prevent loss exposure, brokers assign different level option trading permissions based on a trader’s means and experience:
Level 1 – Covered Calls
Level 2 – Cash-protected Short Puts
Level 3 – Debit Spreads
Level 4 – Credit Spreads
Level 5 – Naked Options
Generally, the higher the options-trading level the higher the potential loss. Selling naked options at level 5 can result in loses far beyond the cost of selling an option.
Suffice to say, short strangles are completely out of the reach of lower-level traders. But maybe not.
Consider the poor-man’s short strangle. This is a strategy that starts with 100 shares of stock. You may have been assigned the shares because you wrote a short put that ended up in-the-money at expiration.
You can leg into this strategy. First, you write a covered call on the shares you own at a strike price above break-even.
Next, If the share price dips even lower, or doesn’t move very much, you can write a short put below the already-beaten-down share price. That short option is a cash-protected put.
Voila. You have a share- and cash-protected short strangle.
One of three scenarios will play out:
The price of the stock goes up beyond the call strike and your shares are called away – hopefully, at a profit.
The price of the stock ends up between the put and call strikes, lowering the cost basis of the shares held by the premiums you collected.
The price of the stock falls below the put strike and you are assigned (buy) another 100 shares – lowering the dollar-average cost of all shares you hold.
Note this is still not a defined-risk trade. You could be exposed to more downside risk if you end up holding twice the number of shares. But this strategy might make sense if you are trading small and have dry powder in reserve.
We have combed the message boards and never found instances of this kind of strategy discussed. We are open to other names for this strategy. At UpTrade, we call it the Poor-man’s Short Strangle.