What Is a Covered Combination?
The term covered combination refers to an options strategy that involves the simultaneous sale of an out-of-the-money (OTM) call and put with the same expiration dates on a security owned by the investor. Put simply, a covered combination is a covered call and a short put position combined together.
Investors can use this strategy to receive premium income through the sale of the call and put. In exchange, they take on the risk of increasing their position in the stock should its price decline below the strike price of the put by the expiration date.
- A covered combination is an investment strategy that involves combining the sale of an out-of-the-money call and put with the same expiration dates.
- Investors who use this strategy may receive premium income through the sale of both the call and put.
- Although they may earn more premium income, investors do assume a greater risk of increasing their position in the stock should its price decline below the strike price.
How Covered Combinations Work
Covered combinations are essentially two different investment strategies rolled into one. As mentioned above, these strategies involve selling a covered out-of-the-money call and an out-of-the-money put—both of which have the same expiration date—at the same time. An OTM call option has a strike price higher than the underlying asset's market price, while an OTM put's strike price is the opposite—it's lower than the asset's price.
Covered combinations are also called covered combos. They provide premium income—the proceeds earned from selling options contracts—from two sources. The first comes from the call and the other from the put. Although they do give the investor premium income, covered combinations also expose them to the risk of having to buy more stock if the stock declines in value.
For this reason, this strategy is best suited for investors who are moderately bullish on a stock and are comfortable with increasing their position in the event of a price decline. It is also used by investors who want additional levels of premium income to enhance their rate of return on a stock or portfolio. Investors who may be interested in making a purchase of half the position now and the remaining half at a lowered price.
Covered combinations are primarily well-suited for bullish investors who don't mind increasing their position even if the stock price drops.
Example of Covered Combination
Here's a hypothetical example to demonstrate how covered combinations work. Let's assume an investor owns stock from Company XYZ which trades at $30 per share. They sell a call option on Company XYZ with a strike price of $33 per share, while simultaneously selling a put option with a strike price of $27 per share. Both the call and put expire in three months.
The options expire worthless for the party who buys them by the end of the three-month period—provided XYZ remains around $30 per share. But the investor, who still owns the stock, is able to pocket the premiums.
But if the price of Company XYZ's stock rises above $33, the investor is forced to sell their stock at $33, since the person who bought the call option will likely exercise the option. In this case, the investor profits up to $33 on the stock, but also gets to keep both premiums since the put option expires worthless for the person who buys it.
If the stock price falls below $27 per share, the put option kicks in. The person who buys the put option will try to sell the stock at $27, which means the investor who sold the option must buy more stock at $27. For every option they sold, they will need to buy 100 shares at $27. This may be beneficial if the investor wants to buy more stock at $27 anyway. With the covered combination, they get the stock they want with the added benefit of receiving the premiums. The major risk in this scenario is if the stock keeps falling. The investor now has a larger position in a declining asset.