I set up a July 2010 strangle on INTC, a stock in which I did not previously hold a position.
First, I bought INTC for $19.97 per share. Then, I took two actions; I wrote covered calls against my newly purchased shares, and I wrote puts to purchase more. The calls have a strike price of $21, and the puts have a strike of $19. That is, by July I will be obliged to sell my new shares for $21, or buy more at $19. I was paid $0.97 for the calls and $1.22 for the puts. The total option premium is $2.19 per share, and remember that I keep that no matter what the outcome of the options at expiration. The possible outcomes are as follows:
IF:
In July, INTC is trading above $21 per share.
I will sell my INTC for $21 per share.
My gain will be:
(sale price - purchase price + option premium) = $21 - 19.97 + 2.19 = $3.22 per share.
Profit = $3.22 per share.
IF:
In July, INTC is trading somewhere between $21 and $19 per share:
I will not be obliged to sell my INTC.
I will not be obliged to buy more INTC.
I will keep the option premium of $2.19 per share.
Profit = $2.19 per share.
IF:
In July, INTC is below $19 per share.
I will not be obliged to sell my INTC.
I will buy more INTC at $19 per share.
Profit = $2.19 per share.
There are two risks involved here; risk to capital, and risk to profit. In the former, my risk is that INTC will have dropped substantially in value by the expiration date. I would be obliged to buy it at $19 even if it was trading for $0.19. Therefore it's important to consider the quality of the underlying security. In this case, I believe INTC is a stable, financially strong company which I would be pleased to buy at $19. I believe the underlying value is there. I would not make this trade if I had doubts about the financial strength or management integrity of this company.
The latter risk, risk to profit, comes into play if my covered calls are exercised. If INTC is trading at $100 per share at expiration, I'm still obliged to sell at $19. In essence, I'm trading all my profit above $19 for the $1.22 premium payment (for that leg). Therefore, I wouldn't make this trade on a stock like AAPL, which is known for it's sharp and unpredictable changes in price. For this trade, I'd also avoid any stock which has an upcoming event which could affect the price, such as FDA approval of a drug.
