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Mar 11, 2016

Synthetic Covered Strangle: IRA Options

By:Josh Fabian

Covered strangles involve buying stock, selling a call and selling a put. In a regular margin account, this strategy can be used without using too much buying power. However, using this strategy in an IRA account requires putting up enough capital to cover both the long stock and the short put. Let’s use Apple to illustrate what this would look like:

  • Buy 100 shares Apple at $97 = $9700 in buying power
  • Sell 1 March 94 Put for a credit of $1.20 = $9280 in buying power
  • Total Capital Required = $18,980

If you’re trading in a small account, or if you just don’t want to put up that much capital to place a trade, there are other actions you can take. For instance, constructing a synthetic equivalent to create a covered strangle. In this episode of IRA Options, Liz and Jenny showed how to create this type of synthetic. Remember, many strategies not available in an IRA can be replicated using a synthetic. It simply requires a little creativity.

To create a synthetic covered strangle, we begin by selling an in-the-money put. Selling an in-the-money put is the synthetic equivalent to buying stock and selling a covered call. Let’s go back to our Apple example but this time, we’re going to use an in-the-money put:

Sell 1 March 98 Put for a credit of $2.80 = $9530 in buying power

Next, we look to sell an out-of-money put. Liz and Jenny like to use a put with a 65% probability of expiring worthless. Back to our example:

  • Sell 1 March 98 Put for a credit of $2.80
  • Sell 1  March 94 Put for a credit of $1.20
  • Total Credit = $4.00
  • Total Capital Required = $18,800

$18,800 is a considerable amount of capital to tie up in one trade. Therefore, we look to buy two even further out-of-money puts. Buying out-of-money puts reduces how much buying power is needed because it limits your risk. Back to the example:

  • Sell 1 March 98 Put for a credit of $2.80
  • Sell 1 March 94 Put for a credit of $1.20
  • Total Credit = $4.00
  • Total Capital Required = $18,800
  • Buy 2 March 88 Put for a debit of $0.33
  • New Total Credit = $3.34
  • New Total Capital Required = $1,266

Buying the far out-of-money puts only dropped the credit received by $0.66. However, it reduced the buying power required by more than $17,500.

If Apple remains above $94.66 come March expiration, we will be profitable on this trade. Our maximum loss on this trade is capped at $1,266. If Apple rallies and closes above our $98 short put, we will keep the entire $3.34. However, at tastytrade, we don’t get greedy. Because this is a defined risk trade, we would look to cover at 50% of max profit or $1.67.

Josh Fabian has been trading futures and derivatives for more than 25 years.

For more on this topic see:

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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