An Illusion: The Covered Straddle

A recent question from a member brings up a topic that is worthy of a full discusssion:

My initial attraction to options came when I realized the potential benefits of put selling. I’ve viewed your video on this topic, and it seems we think alike on this. One approach to put selling that appeals to me is something I understand is called “systematic writing”: namely, sell puts on one-half the position you are prepared to own; if/when you are assigned, sell a straddle for the other half; if called away repeat and if assigned under the put, sell covered calls.

A simple, but effective plan for the premium seller who is BULLISH. Never forget that this strategy does not work in a bear market. But I am certain you already know that.

It appeals to me because by working with half positions it helps avoid the position sizing problem you allude to in your video; and because it provides access to the great premium that an ATM straddle provides, without the risks normally inherent in selling a naked straddle. I would be interested in your views on this.

This is an illusion.

Half positions should not make you comfortable about position sizing. It is trading the full-sized position that must leave you comfortable. If you want to trade 10-lots, then you can sell 5 puts to begin the strategy. But if being short 10 makes you uncomfortable, then 10 is the wrong size. Yes, I know that selling only 4 to begin may leave you wanting more, but do not end up with 10 when 10 is uncomfortable. Suggestion if that applies to you, there is nothing special about 50%. You could sell 5 puts and then and 3 more later. That is not a suggestion. It is only an alternative.

I hope you are familiar with the concept of equivalent positions. Assuming ‘yes’ then you know the covered call is essentially the same position (it is equivalent; same risk, same reward) as being short a put (when the options have same strike price and expiration date). Thus, selling the ATM straddle is nothing more than: a) writing an ATM covered call on the stock you own and b) selling one more put. This time it is an ATM put.

I mention this because I find it helps to look at positions in different ways. I believe that thinking of the straddle as providing ‘great’ premium leads you astray. You merely have the equivalent of being short two puts instead of one. That is what a covered straddle is. In other words, you have doubled position size, as planned. And the premium seems to be so high because you think of the covered straddle as a single position when it is really two naked puts (or two covered calls). I don’t like the thought that you were ‘charmed’ into the covered straddle by a professional options teacher.

The reason we look at the covered straddle as less risky than the naked straddle is because it has zero upside risk. In fact it is a bullish play (short 2 puts). The investment world tends to think of being naked short calls as more risky than being short naked puts. Theoretically that is true (stock can go to infinity), but in practice when we are short a call or a put on a $100 stock, neither sale is more risky than the other when the trader pays even a tiny bit of attention to managing risk.

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