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.
Definition
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.
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
ZYX is above $55 at expiration
The ZYX 50 put option will expire
out-of-the-money and worthless. The investor will be assigned on the ZYX
55 call and is obligated to sell his 100 ZYX shares at the call's strike
price of $55. The result after expiration: no position in either ZYX
stock or options. However, he has received and keeps two option premiums
for having sold both a put and a call.
The investor originally purchased 100 ZYX
for $52 per share, for a total investment of $5,200. After assignment,
the total received from selling these 100 shares at a net price of
$60.25 per share is $6,025. The net stock profit is therefore: $6,025
received - $5,200 paid = $825. This profit represents a return on the
original $5,200 investment in 100 ZYX shares of approximately 15.8% over
three months.
However, when establishing this position the investor also deposited
cash, securing the short put, for a possible purchase of an additional
100 shares if assigned on the downside. Since the put's strike price is
$50, a total of $5,000 ($50 strike price x 100 shares) was deposited.
This brings the total assets committed up front to: $5,200 for 100 ZYX
shares + $5,000 cash deposited = $10,200. Given this, the $825 profit
from assignment on the call represents a return on total assets
committed of approximately 8.1% for three months.
Keep in mind that no matter how high ZYX rises above $55 by expiration,
the investor has the obligation to sell ZYX at the call strike of $55 if
assigned. However, he has taken in both the put and the call premium to
offset some of the upside potential that might be missed.
ZYX is below $50 at expiration
The ZYX 55 call option will expire
out-of-the-money and worthless. The investor will be assigned on the ZYX
50 put and is obligated to buy an additional 100 ZYX shares at the put's
strike price of $50. The result after expiration: a doubled stock
position of long 200 ZYX shares and no option position (they have
expired). However, he has received and keeps two option premiums for
having sold both a put and a call.
The net cost per share for the additional
100 ZYX purchased from the short put assignment is: $50 put strike -
$5.25 combined put/call premium received = $44.75. This meets the
investor's original goal of purchasing 100 additional ZYX shares on a
pullback at a price less than the written put's $50 strike. The investor
is now long the original 100 ZYX shares at $52 and the additional 100
shares at $44.75. The average price for the 200 ZYX shares is therefore
approximately $48.38.
If this investor had originally bought 200 ZYX shares at $52, it would
have cost him $10,400. Since this investor bought only half of the
position at $52 ($5,200 for 100 shares), and the rest on a pullback
taking in two option premiums for a cost of $44.75 ($4,475 for 100
shares), he has now spent a total of $9,675 for his desired 200-share
position.
Keep in mind that no matter how low the stock has fallen below the put's
$50 strike price, the investor has the obligation to purchase an
additional 100 ZYX at $50 per share if assigned. The cash for this
purchase, however, was deposited in his brokerage account when the
covered combination was sold.
ZYX is between the strikes ($50 and $55)
at expiration
In this case both options will expire
out-of-the-money and worthless. The result after expiration: the
investor will not be assigned and so retains his original 100 ZYX shares
purchased at $52. In addition he keeps the combined call and put
premiums of $525, plus any dividend paid to ZYX shareholders. This $525
represents a return on the original $5,200 ZYX investment of
approximately 10.1% for three months. But remember that the investor
also deposited $5,000 cash into his brokerage account at the onset of
this position to secure his written $50 put. Therefore, the $525 premium
received and kept represents a return on the total $10,200 assets
committed of approximately 5.1% for three months.
Since the investor retains the 100 ZYX
shares originally purchased when the combination was sold, the $5.25
combined premium for the call and the put has the effect of lowering the
cost basis for these shares: $52 purchase price - $5.25 premium received
= $46.75 reduced cost basis. This is also the investor's new break-even
point for these 100 shares in the future. He may now choose to sell
another combination against the existing stock position, or hedge the
position in some other way. He is also free to hold the stock and to
profit as long as the shares remain above the new break-even point of
$46.75.
Summary
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.
