How to Strangle Profits From an Uncertain Market

This article is part of our series on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.

If market turmoil and low bond yields have you worried about your portfolio, you aren't alone. Chances are you've positioned your portfolio defensively in strong and healthy businesses. One of my favorite options strategies -- writing covered strangles -- provides solid income, while setting the stage to buy more of the defensive portfolio holdings you already know and love at attractive prices.

Writing covered strangles
A covered strangle combines three investment positions to achieve maximum rewards from a mild upward move in the stock. It may sound complicated, but it isn't.

  1. You own 100-share blocks of a stock.
  2. You write out-of-the-money put options.
  3. You write out-of-the-money call options.

In other words, the current stock price falls between the two strike prices you choose -- meaning you've "strangled" that current price.

For an example, let's take consumer products giant Procter & Gamble (NYSE: PG  ) , an attractive stock to use with the strangle strategy. Shares currently trade near $62.50, right around your $65 estimate of intrinsic value. You love the protection of P&G's steadily rising dividend and 3.4% yield, but think shares might be kept in check if consumers trade down from the company's premium brands in a still-weak economy. In plain English, setting up each of the three legs above would say the following:

  1. P&G is an investment you're comfortable with, and which you think has limited downside.
  2. You'd be happy to own more shares if they fell a little bit -- say, to $60. (Write a $60 put.)
  3. You'd be happy to let your current shares go if they rise to fair value -- $65. (Write a $65 call.)

A covered strangle allows you to retain the stock's upside until it hits your chosen call strike price ($65), get paid income for writing both the put and call options -- and keep any dividends the stock pays along the way.

How could it play out?
There are three likely outcomes here. If P&G shares fall below $60, you'd be obligated to buy more shares. Alternatively, if shares jump to $65 or higher by expiration, you'll have to sell your existing shares at $65. But if shares bop between $60 and $65, you hang onto your existing shares. In each case, you bet to keep the option premium you were paid up front for writing the puts and the calls.

What happens at expiration?

Flat Stock

Rise to $65 or Higher

Fall to $60 or Lower

You own P&G stock at today's price $62.50 $62.50 $62.50
You write January $60 put options $2.44 $2.44 $2.44
You write January $65 call options $1.57 $1.57 $1.57
Profit on the stock at expiration $0.00 $2.50 ($2.50)
Dividend payment in October $0.53 $0.53 $0.53
Dividend payment in January $0.53 $0.53 $0.53
Profit on the options $4.01 $4.01 $4.01
Net profits $5.07 $7.57 $2.57
Ending stock position Original position Sell your shares Buy more shares

Source: Yahoo! Finance; author calculations.

As you can see, a covered strangle gives a wide profit range while paying you healthy income.

Finding candidates to strangle
When considering a covered strangle, you first have to be OK with the possibility of owning more shares at a cheaper price, or potentially selling your existing shares if they rise. The ideal candidates come from the defensive stocks you already own -- healthy stocks that you feel have limited downside. And because you own shares over the life of the strangle, it pays to find stocks that will throw a dividend payment your way, too. Here are a few that fit the bill:

Company

Market Cap (thousands)

Debt-to-Capital

EV-to-EBITDA

Dividend Yield

Abbott Labs (NYSE: ABT  ) $78,732 40.8% 8.5 3.8%
Cisco Systems (Nasdaq: CSCO  ) $89,928 26.3% 6.1 1.5%
ConocoPhilips (NYSE: COP  ) $90,578 28.3% 3.9 4%
Duke Energy (NYSE: DUK  ) $25,402 45.6% 8.4 5.2%
Johnson & Johnson $174,643 23.2% 8.4 3.6%
Transocean (NYSE: RIG  ) $18,834 34.6% 8.1 5.4%
United Parcel Service (NYSE: UPS  ) $64,889 59.4% 8.8 3.1%

Source: Capital IQ, a division of Standard & Poor's.

What can go wrong?
The main danger in writing covered strangles is that you take on the downside risk of having to buy more shares. If the stock you've chosen tanks, the shares you already own lose value, and you've promised to buy additional shares at the put strike price. It's a double whammy. So be sure to choose a stock that you've done your homework on. By the same token, avoid highfliers that are likely to surge past your written call strike. If you've found a highflier, just be happy to hold the share,  and don't play around with writing calls to give away the upside. (For these sorts of stocks, buying calls on pullbacks is a better strategy.)

Remember, if your written put options get exercised, you'll have to buy more shares, which will double your position size in the underlying stock. Make sure you're comfortable with this allocation before writing a covered strangle.

The bottom line
You don't have to accept low bond yields and a market full of uncertainty. By writing covered strangles, you can bolster your portfolio with added income, and seize the opportunity to fill out positions in your favorite defensive names if the market turns south. With the risks accounted for, this strategy is a reasonably conservative way to take advantage of healthy stocks you think will likely plod along in a tough environment.

Stay tuned throughout our options investing series and get the strategies you need to earn more from your investments. Click back to the series intro for links to the entire series.

Bryan Hinmon does not own shares of any company mentioned. The Motley Fool owns shares of Abbott Laboratories, Johnson & Johnson, Transocean, and United Parcel Service. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Procter & Gamble, Abbott Laboratories, Johnson & Johnson, and Cisco Systems, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 23, 2011, at 10:56 PM, HughWillFool wrote:

    I wholeheartedly agree with with you, except on one point - your "highflyer". I agree that if you do know when yours will take off, you might think twice before writing a call on it.

    On the other hand, those stocks we expect to be our "highflyers" also tend to be volatile. And calls on volatile stocks are quite a bit pricier - and hence more rewarding to write - than ones on more stable equities - ("large cap high dividend" stocks, for example).

    Because of the ever-eroding "time value" of an option, by CONSISTENTLY writing a series of near-term slightly out-of-the-money covered calls - one every month or two, and rolled out as they expire - you can build a very good rate of return. - And if your stock's price edges up, you adjust to a higher strike when you write the next call.

    If your "highflyer" occasionally breaks out, you can "close" (buy your option back) just before it expires. You will lose money when you "close" the option you had written. But the loss will be more than fully offset by the somewhat highter gain you will have on your "highflyer" itself. (Mainly because the call's "time value" has eroded away since when you wrote it, and also because you had written the call slightly out-of-the money).

    Obviously, you wouldn't want to sell a call on it just before your "ten-bagger" makes its big breakout, as your own profit would be comparatively small, with most of the gains going to the call's buyer.

    ... And what's more, if you can correctly anticipate when the breakout will happen, you can multiply your profit by buying calls, not writing them.

    But with the right (i.e., volatile) stocks, (which you may already have in your own portfolio), you can build a strong and steady stream of income from the series of options, to produce returns in the range of 40% to 50% per year, with less risk than buying "the One", and then just sitting on it for a year or two, waiting for the big breakout you had hoped for. - Or worse yet, buying calls, and having them erode - and ultimately expire worthless - when the breakout is delayed.

    (Let me tell you sometime about "MELA", a Fool recommendation that bit me exactly this way).

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