Covered Combinations

 

The covered combination is a purchase of underlying shares along with the sale of an out-of-the-money call and an out-of-the-money put. For this reason it can be viewed as two separate strategies in one: a covered call, and a cash-secured put. An investor using this strategy has a target of ultimately owning a certain number of underlying shares. He purchases half of the shares when the combination is sold, and receives combined premiums for selling an equivalent number of both call and put contracts covered by those shares. At the same time he deposits cash for the purchase of stock from possible assignment on the short put. The investor is then positioned and should be committed to:

  • Selling his originally purchased shares in an up-market if assigned on the short call(s), and at a better rate of return than a simple covered call writer
  • Doubling his stock position on a pullback if assigned on the short put(s)
  • Increasing his return and lowering his break-even point on the originally purchased shares, which he retains in a static market if no assignment is received

Note: Assignment prior to expiration
It is always possible that the underlying stock's price will fluctuate above the call's strike price and below the put's strike price during this position's lifetime. If this should happen it's always possible that the investor will be assigned before expiration. Early assignment might be expected on a short in-the-money call before the underlying stock pays a dividend, when the time premium portion of the call's current market premium is less than the dividend amount. For puts, many option professionals will exercise deep in-the-money puts before expiration when their premiums have little or no time value.



Covered Combinations Worksheet


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