The covered combination is a three-part strategy that sets targets to sell/reduce your current stock position or accumulate additional shares. The first part of the strategy is to pick the stock and purchase only half of the desired number of shares. The second part is to sell covered calls against the purchased shares at or near the desired selling price. The final step is to sell cash-secured puts to acquire the remaining number of shares desired.
A covered combination strategy is typically implemented on a share-for-share basis e.g., buy 500 XYZ, sell 5 XYZ calls, and sell 5 XYZ puts. The short calls contain an obligation to sell shares at the strike price until expiration. The short puts contain an obligation to buy shares at the strike price until expiration. The money to buy the additional shares is deposited in an interest bearing account until needed.
The motivation behind the covered combination is a belief that the stock will trade in a narrow range. With such a forecast, an investor might be willing to sell the position if the price moves higher. Additionally, the investor might be willing to buy additional shares at a lower price.
Assume your client is interested in purchasing 1,000 shares of XYZ but forecasts that XYZ will trade in a narrow range for the next 60 days. To simplify the example commissions and other charges are not included. Be aware! The inclusion of these costs can impact performance.
Consider this covered combination as a potential strategy:
Buy 500 XYZ @ $53.00
Sell 5 60-day 55 calls @ $2.00
Sell 5 60-day 50 puts @ $1.50
The initial purchase of 500 shares is half of the desired total position. The short calls contain an obligation to sell the 500 shares at $55, and the short puts contain an obligation to buy 500 additional shares. Remember: the money to acquire the additional shares is set aside in an interest bearing account, available when/if your client is required to buy those shares.
In this example, the maximum gain results if the calls are assigned and the stock is sold. If the calls are assigned, your client must sell the owned 500 shares at $55. However, both premiums are kept as income as the short put will expire at expiration. The maximum profit is the rise of the stock, $2 ($55 -$53), plus the total premium received, $3.50, for a total of $5.50 profit. The risk, however, is substantial. If the stock falls below $50, and if the puts are assigned, then your client will own 1,000 XYZ at an average price of $49.75. The second 500 shares are purchased at an effective price of $46.50 ($50 - $3.50), so the average price is calculated as follows: (500 x $53 + 500 x $46.50) / 1,000 = $49.75. If the puts are assigned, then your client will have accumulated the desired 1,000 share position.
No discussion would be complete without mentioning the possibility of early assignment. While the risk may be small you need to be aware that this may occur. Typically, early assignment only happens near an ex-dividend date when options are deep in-the-money. Furthermore, early assignment may not be an unwelcome event. After all, the original reason we chose this strategy was to sell the stock on a price rise or accumulate additional shares on a decline.
The covered combination allows your client to target both a higher selling price and a lower buying price. The effective selling price in the example above is $58.50, and the effective buying price for the additional 500 shares is $46.50. Another benefit is that, if the stock remains unchanged, then both options expire. In this case, your client keeps both premiums. The potential negatives are limited profit potential and risk equivalent to purchasing 1,000 shares at an average price of $49.75.
If you and your client think that a stock will trade in a narrow range, then the covered combination may give you something to do when investing/trading opportunities seem scarce.
FOR REGISTERED REPRESENTATIVES ONLY. NOT FOR CUSTOMER DISTRIBUTION.
Options are not suitable for every investor. For more information, consult your investment advisor. Prior to buying and selling options, a person must receive a copy of Characteristics and Risks of Standardized Options which is available from your broker or from The Options Clearing Corporation (OCC) by calling 1-888-OPTIONS, or by writing to OCC at One North Wacker Dr. Suite 500, Chicago, IL 60606.