Who Should Consider Using Covered Combinations?
• An investor who is moderately bullish on a particular stock.
• A covered call writer who is looking for a strategy that might help enhance his
return further.
• An investor who would like to buy a particular stock but is not quite sure whether
this is the best time to buy. He might be interested in buying only half of the
position now and the remainder on a pullback.
The Covered Combination is a strategy that allows
the investor to receive premium income in
exchange for being willing to double his stock
position in the event of a downward price move,
enhance his rate of return on the upside, and lower
his breakeven price in a static market.
Although the covered combination may not be
suitable for every investor, anyone who has
invested in stocks or covered call writing might
want to consider selling a covered combination.
The call portion of the combination could be
written against stock that is already owned at the
time the combination is written.
Definition
A covered combination is simply the sale of a
covered call and a cash-secured put. Covered call
writing is either the simultaneous purchase of stock
and the sale of a call option or the sale of a call
option against a stock currently held. The writer is
obligated to sell the stock should the call be
assigned. Generally, the call will be assigned only if
the price of the underlying stock rises above the
strike price.
Selling a cash-secured put involves selling a put and
depositing the money for the purchase of stock at
the investor's brokerage firm (generally, this is
invested in short-term instruments). The purpose of
having the money in a brokerage account is to
assure that the funds are available to purchase the
stock should the put be assigned to the investor's
account. The buyer of the put will generally exercise
the option only if the underlying stock falls below
the strike price. If the stock declines below the strike
price, the investor is obligated to purchase the stock
at the put strike price no matter how low it has
declined.
In other words, when writing a covered
combination, the underlying stock is held at the
same time that both puts and calls are sold. By
selling both puts and calls, two premiums are
received to lower the cost of the position. If the
stock does not move to the strike prices by
expiration, the benefit of both premiums is
retained. New puts and calls could be sold as long
as the investor's outlook on the stock has not
changed. If the stock rises above the call strike the
investor will be obligated to sell the stock at the
strike price, but remember, the breakeven was
lowered by the two premiums that the investor
received. If the stock drops below the put strike, the
investor will be assigned and the stock will have to
be purchased, but once again two premiums were
brought in to offset some of the stock cost. In other
words, the investor will be “paid” to accept the
obligation to double the number of shares of a stock
that he is willing to own. If this happens, he could
then continue to sell calls and bring in additional
premium.
Goal: Increase Returns or Double
Your Stock Position
Let’s take the example of an investor who would like
to buy 1,000 shares of ZYX. He thinks that it is a
good buy at 51, but feels that the stock might pull
back in the near term. He is concerned with market
or stock volatility, but not enough to stop him from
making the purchase now. Instead of buying all
1,000 shares at this time, 500 shares could be
purchased and a combination sold. If the stock
declines, the investor may be obligated to purchase
additional stock; and, if the stock rises, the investor
may be obligated to sell the stock. However, if the
stock remains between the call strike and put strike,
both premiums will be retained with no obligation
at expiration. Commissions have not been taken
into consideration in these examples; however, they
can have a significant effect on your returns.
The transaction looks like this:
Buy 500 shares ZYX at 51
$25,500
Sell 5 three-month 55 calls at 2.25
1,125
Sell 5 three-month 45 puts at 2
1,000
Net Cost = $23,375
($46.75 avg. price per share)
I. ZYX is above 55 at expiration.
The put options will expire worthless and the
investor will be assigned on his call options. In other
words, ZYX will be called away and the investor
will have to sell the stock at 55. However, he has
received two option premiums for having sold the
puts and the calls.
Purchase Stock
Less Call Premium
Less Put Premium
Breakeven Price
(or Net Cost Per Share)
51-1/4
-2.25
-2-1/4
46.75
Stock Called Away at Strike Price 55-1/4
Less Breakeven Price
-46.75
Proceeds from Sale
+8.25
The proceeds from the sale of $8.25 is a 17.6%
return on investment in three months.
Keep in mind that no matter how high ZYX rises
above 55, the call seller has the obligation to sell
ZYX at 55. However, he has taken in both the put
and the call premium to offset some of the upside
potential that might be missed.
II. ZYX is between the strikes (45 and
55) at expiration.
The seller will not be assigned and the stock is
retained along with the two premiums and any
dividend paid.
Purchased Stock
51
Less Call Premium
- 2.25
Less Put Premium
-2
Breakeven Price
46.75
The stock is still held, but the breakeven is now
reduced by the premiums received from selling the
combination. This position results in a loss if ZYX
is below 46.75. The investor may now choose to sell
another combination against the existing stock
position, if his opinion on the underlying stock has
not changed. By selling both an out-of-the-money
put and a call a second time, the breakeven on the
stock would once again be reduced by the
premiums received.
III. ZYX is below 45 at expiration.
Having sold the put the investor has the obligation
to purchase ZYX at 45, no matter how low the
stock has fallen below the strike. However, he has
now doubled his position on a stock that he was
willing to own and will have received premiums
from having sold the options.
Owns 500 shares
Less Call Premium
Less Put Premium
Breakeven/Net Cost
Purchased 500 shares
(put assignment)
51
-2.25
-2-1/4
46.75
45
New Total Stock Position: 1000 Shares @ 46
The investor is now long 500 shares at 46.75 and
500 shares at 45.25. The average price per share/
breakeven after the put is assigned is 46.
If this investor had originally bought 1000 shares of
ZYX at 51, it would have cost him $51,000. Since
this investor bought half of the position at 51 and
the rest on a pullback and took in two option
premiums in the process, a new breakeven of 46 has
been created. The position has a net cost of
$46,000.
This example uses short-term options. If an investor
would like to use this strategy but over a longer
time horizon, LEAPS are available. LEAPS®, Longterm Equity AnticiPation SecuritiesTM, are simply
long-term stock and index options.
Assignment prior to expiration
The possibility always exists of the stock’s price
fluctuating above the call strike price and below the
put strike price prior to expiration. If this should
happen, the original stock position would be called
away and the investor would have to buy shares of
the stock due to the assignment of the short put. To
avoid this from happening, should the investor be
assigned on one side, he then might want to close
out the other side. Otherwise, the investor would be
exposed to any price movement beyond the
remaining strike price.
Summary
The Covered Combination allows an investor to be
paid to have the obligation to add to his position in
a stock he already owns and likes, while lowering his
breakeven on the purchase. Also, it gives the covered
call writer an opportunity to enhance his rate of
return because he has received a premium for having
sold a put as well as a call. The covered combination
writer adds to his position on a pullback, lowers his
breakeven in a static market, and has a better rate of
return than a covered call writer in an up-market.
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Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of
Standardized Options. Copies may be obtained by contacting your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation at
www.theocc.com. In order to simplify the computations, commissions, dividends, fees, margin interest and taxes have not been included in the examples used
in this document. These costs will impact the outcome of stock and options transactions and must be considered prior to entering into any transactions.
Investors should consult their tax advisor about any potential tax consequences. The strategy discussed above is strictly for illustrative and educational purposes
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