Covered Combinations Example

How to Use the Covered Combination to Increase Returns or Double a Stock Position

Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.

Example

An investor would like to buy 200 shares of ZYX, which is currently trading for \$52 per share. He thinks that it's a good buy at this price level, but feels that the stock might pull back in the next few months. He's concerned with market volatility, but not enough to stop him from making a partial purchase at this point. Instead of buying all 200 ZYX shares, he purchases only 100 shares at \$52. On the upside, if ZYX increases in price the investor is willing to sell his 100 shares around \$55 or above. On a pull back, he's willing to purchase an additional 100 ZYX shares at a price somewhere below \$50. Given these motivations, the investor decides to write a combination, and selects an available out-of-the-money ZYX 55 call and an out-of-the-money ZYX 50 put, both expiring in 90 days.

He sells the ZYX call for a quoted price of \$2.75 and the ZYX put for \$2.50, receiving a premium amount of: \$2.75 call premium + \$2.50 put premium = \$5.25, or \$525.00 total. The 100 ZYX shares he owns cover the written call. He also deposits into his brokerage account the full cash purchase amount of \$5,000 (\$50 put strike x 100 shares) for the additional 100 shares he'll purchase if assigned on the written put, so this contract is cash-secured.

The investor is positioned in the market just as he wants. If ZYX declines, he's being paid for the obligation to purchase an additional 100 shares at a lower price if assigned on the short ZYX 50 put. As a result, he would own his desired 200 shares, but at an average cost less than the current \$52 per share level. On the other hand, if the stock rises he'll sell his original 100 ZYX at \$55 per share if assigned on the short \$55 call. If ZYX closes at expiration between the call strike of \$55 and the put strike of \$50, both options will expire out-of-the-money and with no value. The total premium amount of \$525 will be retained with no further option-related obligations.

The investor's covered combination transaction looks like this:

Consider three possible scenarios at expiration:

• ZYX closes above the call strike of \$55
• ZYX closes below the put strike of \$50
• ZYX closes between \$50 and \$55

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