How to Strangle Profits From an Uncertain Market

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This article is part of ourseries 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 (NYS: 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 PG 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 positionOriginal positionSell your sharesBuy 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 (NYS: ABT) $78,73240.8%8.53.8%
Cisco Systems (NAS: CSCO) $89,92826.3%6.11.5%
ConocoPhilips (NYS: COP) $90,57828.3%3.94%
Duke Energy (NYS: DUK) $25,40245.6%8.45.2%
Johnson & Johnson$174,64323.2%8.43.6%
Transocean (NYS: RIG) $18,83434.6%8.15.4%
United Parcel Service (NYS: UPS) $64,88959.4%8.83.1%

Source: Capital IQ.

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 introfor links to the entire series.

At the time this article was published 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 serviceshave 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 servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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