What is a ‘Covered Combination’
A covered combination is an option strategy that involves the simultaneous sale of an out-of-the-money call and put, with the same expiration dates, on a security owned by the investor. It is a combination of a covered call and a short put position. The strategy enables the investor to receive premium income through the sale of the call and put. In exchange, they take on the risk of increasing their position in the stock should its price decline below the strike price of the put by the expiration date.
Breaking Down the ‘Covered Combination’
Covered combinations give the investor premium income, but also expose them to the risk of having to buy more stock if the stock declines in value.
Assume an investor owns stock XYZ that is trading at $30. They sell a call option on XYZ with a strike price of $33 and simultaneously sell a put option with a strike price of $27. Both the call and put expire in three months.
If XYZ stays around $30, in three months time the options will expire worthless (to whoever bought them). The investor pockets the premiums and still owns the stock.
If the price of XYZ rises above $33, the investor is forced to sell their stock at $33, since the person who bought the call option will likely exercise the option. In this case, the investor profits up to $33 on the stock, but also gets to keep both premiums since the put option expires worthless (for the person who bought it).
If the price of XYZ falls below $27, then the put option kicks in. The person who bought the put option will look to sell the stock at $27, which means the investor who sold the option much buy more stock at $27. For every option they sold they will need to buy 100 shares at $27. This may be beneficial if the investor wanted to buy more stock at $27 anyway. With the covered combination, they get the stock they wanted but have the added benefit of receiving the premiums. The major risk in this scenario is if the stock keeps falling. The investor now has a larger position in a declining asset.
Covered combinations are used by investors who are moderately bullish on a stock and are comfortable with increasing their position in the event of a price decline. It is also used by investors who are looking for additional levels of premium income to enhance their rate of return on a stock or portfolio.