Who Should Consider Writing Covered Combinations?
- An investor who is moderately bullish on a particular stock.
- A stock-owning investor who is looking for a strategy that might help enhance his return further than with a simple covered call.
- An investor who is not sure this is the best time to establish a position in a particular stock, but might be interested in buying only half of the position now and the remainder on a pullback at a reduced price.
The covered combination is a strategy that allows an investor to receive premium income in exchange for agreeing to double his stock position in the event of a downward price move, enhancing his rate of return on owned shares on the upside, or lowering the break-even point on those owned shares in a static market. Anyone who has invested in stocks or written a covered call might want to consider this strategy. The shares covering this combination can be previously purchased or bought at the same time the combination is written.
A covered combination is simply two strategies in one: the simultaneous sale of both a covered out-of-the-money call and an out-of-the-money cash-secured put, both with the same expiration month. Two premiums are therefore received, one for the call and another for the put. If the investor owns 100 shares of underlying stock then these shares cover the written call on the upside. If the full cost of purchasing 100 additional shares is also deposited in the investor's brokerage account, then this cash secures the written put on the downside if he is assigned. Consider three possible ways to view this strategy's performance, depending on movement of the underlying stock's price.
On the upside, above the short call's higher strike price, this strategy performs like a covered call. If the underlying stock closes above the call's strike price at expiration the investor will most likely be assigned on this contract, but the short put (with a lower strike price) will expire out-of-the-money and with no value. He will be obligated to sell his 100 shares at the call's strike price, as he was willing to do when selling this combination. However, since he received two premiums, one for the written call and one for the written put, the net sale price for those shares will be the call's strike price plus the combined premium amount. If only a single covered call had been written on his 100 shares then he would have only the single premium from its sale to increase the shares' net sale price on assignment, and thus the return on his 100-share investment.
On the downside this strategy performs like a cash-secured put. If the underlying stock closes at any price below the short put's lower strike price at expiration, the written call will expire out-of-the-money and with no value, but the investor can expect assignment on the written put. In this case he'll be obligated to purchase an additional 100 shares, as he was willing to do when this position was established, with the cash deposited in his brokerage account. However, the net purchase price for these 100 shares will be the put's strike price less the combined call and put premium amounts received when these options were sold.
If the underlying stock closes between the higher strike price of the call and the lower strike price of the put at expiration, both options expire out-of-the-money and with no value. In this case the investor keeps the combined call and put premium amounts received from the original sale of these contracts. This premium could be viewed as income generated from the original 100 shares of underlying stock purchased to cover the written combination, enhancing the return on this investment. In addition, the combined call and put premiums the investor keeps in effect lowers his cost basis for these 100 shares, and results in a lower break-even point for holding them.