Covered Combination Explained

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Covered Combination

The covered combination, also known as the covered strangle, is a limited profit, unlimited risk strategy in options trading that involves selling equal number of out-of-the-money calls and puts of the same underlying security, strike price and expiration date while owning the underlying stock.

Covered Combination Construction
Long 100 Shares
Sell 1 OTM Call
Sell 1 OTM Put

Limited Profit Potential

Maximum gain for the covered combination is achieved when the underlying stock price on expiration date is trading at or above the strike price of the call options sold. This is the price where the trader’s long stock gets called away for a profit plus he gets to keep all of the initial credit received when he entered the trade.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Purchase Price of Underlying + Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Unlimited Risk

Large losses can be experienced when writing a covered combination when the underlying stock price makes a strong move downwards below the breakeven point at expiration. This strategy loses money twice as fast as a regular covered call write as the covered combination loses not only on the long stock position but also on the short put.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the covered combination position can be calculated using the following formula.

  • Breakeven Point = (Purchase Price of Underlying + Strike Price of Short Put – Net Premium Received) / 2

Example

Suppose XYZ stock is trading at $52 in June. An options trader executes a covered combination strategy by selling a JUL 50 out-of-the-money put for $100 and a JUL 55 out-of-the-money call for $100 while purchasing 100 shares of XYZ for $5200. The total premiums received for selling the options is $200.

On expiration in July, if XYZ stock rallies above the strike price to $57, the JUL 50 put expires worthless while the JUL 55 call expires in the money and the 100 shares get called away for $5500, producing a gain of $300 on the long stock position. Including the $200 in premiums received upon entering the trade, the total profit comes to $500 which is also the maximum profit attainable.

However, if the stock price drops below the breakeven to $45, the JUL 55 call expires worthless but the naked JUL 50 put and long stock position suffer large losses. The short JUL 50 put is now worth $500 and needs to be bought back while the long stock position has lost $700 in value. Factoring in the $200 premiums received earlier, the total loss comes to $1000.

Note: While we have covered the use of this strategy with reference to stock options, the covered combination is equally applicable using ETF options, index options as well as options on futures.

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Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the covered combination in that they are also bullish strategies that have limited profit potential and unlimited risk.

Covered Combo

The covered combo consists of writing both a covered call and a naked put on the same stock. You receive double premium, but you may end up having to sell the stock or purchase more.

What is a Covered Combo?

Basically, you set up this trade by first owning or purchasing 100 shares of a specific stock. Then you open two separate option positions by writing 1 out of the money covered call and 1 out of the money naked put.

You would collect premium from both short options, which would be your realized profit if the stock closed at expiration anywhere between the two strike prices (so that both options would expire worthless).

Not clear on all the terminology? Check out the Options Trading Education resource page.

If, however, the share price closed below the strike price of the put, you would be obligated to purchase an additional 100 shares of the stock at that strike price.

And if the share price closed above the strike price of the call, you would be obligated to sell your original 100 shares at the strike price of the call.

Covered Combo Overview

The covered combo is an intriguing option trading strategy. There are different schools of thought as to whether it’s ingenious and clever, or whether it’s self-defeating and dumb.

But the most important thing to realize is that despite its characterization and description, the covered combo option income strategy is essentially two separate and distinct strategies lumped together: a covered call and a naked put.

This is not a single transaction or strategy.

Writing the naked put will be collateralized by cash (or possibly by existing stock positions).

Yes, you’re getting two sources of premium. But you’re not getting them at any better rate or advantage than if you’d set up either one of those positions individually.

Covered Combo Example

The XYZ Zipper Company is currently trading for $32.50/share. Let’s assume you were fortunate enough to purchase 100 shares of the stock two or three months earlier at $30/share.

You think it’s a solidly run company, but it’s not about to triple in price anytime soon. In short, although you like the stock, in the interest of maximizing profits, you would be willing to sell your position in the near term. And, what the hell? You wouldn’t mind picking up more shares if the price pulled back some.

You decide to employ the covered combo option trading strategy:

  • You sell a covered call three months out at the $35 strike price for a $1.50/contract premium
  • Additionally, you write a naked put, also three months out, at the $30 strike price for another $1.50/contract premium
  • In exchange for pocketing $300 in premium, you obligate yourself to potentially having to either sell your existing position at $35/share or purchase another 100 shares at $30/share
  • And if, at expiration the stock is still somewhere in that $30-35 range? Both options expire worthless and you’ve successfully booked $300 in option income

Covered Combos – Scenarios

Not to be repetitive, but the possible outcomes are:

  • The stock closes $30-35/share. You’ve done very well for yourself. The buy and hold investor would have virtually nothing to show for those same three months (excluding dividends). But your $300 in premium in effect serves as a special 10% dividend (calculated off your original $30/share purchase) or a 10% reduction of your original cost basis (from $30/share to $27/share).
  • The stock does well over the next three months and cruises up to $40/share. You really can’t complain, but you would’ve done better if you hadn’t tried to get fancy and set this trade up in the first place ($1000 gains vs $800 gains). The covered call portion of the trade forced you to sell your 100 shares for $35/share. You miss out on a full $5/share in capital appreciation, but that’s somewhat offset by the $3/share you collected in option premium.
  • The stock runs into trouble and finishes at $25/share. This is probably not the scenario you envisioned when you first set up the trade. You now own 200 shares of The XYZ Company. When the naked put was assigned to you, you were obligated to purchase your second position in the stock at $30/share (ironically, that’s what you paid for your first 100 shares as well).

But because of all the collected premium, your adjusted cost basis lowers from $30/share to $28.50/share ($6000 less $300 = $5700 divided by 200 shares = $28.50/share). That’s better at least than if you’d simply bought the entire 200 shares at the time of your original investment and then done nothing at all involving options.

Covered Combos – Scenarios

Depending on your objectives, you can choose strike prices either farther out of the money or closer to being at the money.

For example, instead of a $30-$35 range in the scenarioe above, you could write the covered call at the $37.50 strike price and sell the naked put at the $27.50 strike price.

You would receive less income, of course, but you would also increase the odds that both options would expire worthless.

You could conceivably repeat this approach again and again (not the necessarily at the same strike prices, but with the larger range in mind) as an effort to generate smaller but more consistent amounts of regular income.

Or you could go the opposite route and write both the covered call and the naked put right at the money.

In our initial XYZ Zipper Company example, that would be $32.50/share.

If you set up the covered combo this way, there’s no middle ground. When the dust settles, you’ll own either 0 shares or you’ll own 200 shares.

But you will also have collected a whole lot of premium which should offer some reasonable protection against big moves in the stock.

Pros and Cons of Covered Combos

There are both advantages and disadvantages to the covered combo option trading strategy.

Advantages

  • Best suited for the investor/trader who has plenty of cash in a brokerage account already receiving a decent money market rate.
  • Enables you to write farther out of the money options and receive a comparable amount of premium than by selling either covered calls or naked puts alone.
  • Theoretically forces you to buy low and sell high, although this is a relative measure and is only effective if the underlying stock is range bound.

Covered Straddle

What Is a Covered Straddle?

A covered straddle is an option strategy that seeks to profit from bullish price movements by writing puts and calls on a stock that is also owned by the investor. In a covered straddle the investor is short on an equal number of both call and put options which have the same strike price and expiration.

How Covered Straddles Work

A covered straddle is a strategy that can be used to potentially profit for bullish price expectations on an underlying security. Covered straddles can typically be easily constructed on stocks trading with high volume. A covered straddle also involves standard call and put options which trade on public market exchanges and works by selling a call and a put in the same strike while owning the underlying asset. In effect it is a short straddle while long the underlying.

Similar to a covered call, where an investor sells upside calls while owning the underlying asset, in the covered straddle the investor will simultaneously sell an equal number of puts at the same strike. The covered straddle, since it has a short put, however, is not fully covered and can lose significant money if the price of the underlying asset drops significantly.

Key Takeaways

  • A covered straddle is an options strategy involving a short straddle (selling a call and put in the same strike) while owning the underlying asset.
  • Similar to a covered call, the covered straddle is intended by investors who believe the underlying price will not move very much before expiration.
  • The covered straddle strategy is not a fully “covered” one, since only the call option position is covered.

Example of Covered Straddle Construction

As in any covered strategy, the covered straddle strategy involves the ownership of an underlying security for which options are being traded. In this case, the strategy is only partially covered.

Since most option contracts trade in 100 share lots, the investor typically needs to have at least 100 shares of the underlying to begin this strategy. In some cases, they may already own the shares. If the shares are not owned the investor buys them in the open market. Investors could have 200 shares for a fully covered strategy, but it is not expected that both contracts be in the money at the same time.

Step one: Own 100 shares with an at the money value of $100 per share.

To construct the straddle the investor writes both calls and puts with at the money strike prices and the same expiration. This strategy will have a net credit since it involves two initial short sales.

Step two: Sell XYZ 100 call at $3.25 Sell XYZ 100 put at $3.15

The net credit is $6.40. If the stock makes no move, then the credit will be $6.40. For every $1 gain from the strike the call position has a -$1 loss and the put position gains $1 which equals $0. Thus, the strategy has a maximum profit of $6.40.

This position has high risk of loss if the stock price falls. For every $1 decrease, the put position and call position each have a loss of $1 for a total loss of $2. Thus, the strategy begins to have a net loss when the price reaches $100 – ($6.40/2) = $96.80.

Covered Straddle Considerations

The covered straddle strategy is not a fully “covered” one, since only the call option position is covered. The short put position is “naked”, or uncovered, which means that if assigned, it would require the option writer to buy the stock at the strike price in order to complete the transaction. However, it is not likely that both positions would be assigned.

While gains with the covered straddle strategy are limited, large losses can result if the underlying stock tumbles to levels well below the strike price at option expiration. If the stock does not move much between the date that the positions are entered and expiration, the investor collects the premiums and realizes a small gain.

Institutional and retail investors can construct covered call strategies to seek out potential profits from option contracts. Any investor seeking to trade in derivatives will need to have the necessary permissions through a margin trading, options platform.

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