What Is a Covered Combination?
The term covered combination alludes to an options strategy that includes the simultaneous sale of a out-of-the-money (OTM) call and put with a similar expiration dates on a security owned by the investor. Put essentially, a covered combination is a covered call and a short put position combined together.
Investors can utilize this strategy to receive premium income through the sale of the call and put. In exchange, they face the risk challenges expanding their position in the stock should its price decline below the strike price of the put by the expiration date.
How Covered Combinations Work
Covered combinations are basically two different investment strategies moved into one. As referenced over, these strategies include selling a covered out-of-the-cash call and an out-of-the-cash put — the two of which have a similar expiration date — simultaneously. 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 inverse — it's lower than the asset's price.
Covered combinations are additionally called covered combos. They give premium income — the proceeds earned from selling options contracts — from two sources. The main comes from the call and the other from the put. In spite of the fact that they in all actuality do give the investor premium income, covered combinations likewise open them to the risk of purchasing more stock if the stock declines in value.
Consequently, this strategy is best appropriate for investors who are moderately bullish on a stock and are comfortable with expanding their position in the event of a price decline. It is likewise utilized by investors who believe that extra levels of premium income should improve their rate of return on a stock or portfolio. Investors who might be keen on making a purchase of half the position now and the leftover half at a brought down price.
Covered combinations are fundamentally appropriate for bullish investors who wouldn't fret expanding their position even assuming the stock price drops.
Illustration of Covered Combination
Here is a theoretical guide to demonstrate how covered combinations work. We should expect an investor possesses 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 90 days.
The options terminate worthless for the party who buys them toward the finish of the three-month time frame — gave XYZ stays around $30 per share. Yet, the investor, who actually possesses the stock, can pocket the premiums.
Yet, assuming the price of Company XYZ's stock transcends $33, the investor is forced to sell their stock at $33, since the person who bought the call option will probably exercise the option. In this case, the investor profits up to $33 on the stock, yet in addition will keep both premiums since the put option terminates worthless for the person who buys it.
In the event that 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, and that means the investor who sold the option must buy more stock at $27. For each option they sold, they should buy 100 shares at $27. At any rate, this might be beneficial to buy more stock at $27. With the covered combination, they get the stock they need with the additional benefit of getting the premiums. The major risk in this scenario is assuming that the stock keeps falling. The investor presently has a bigger position in a declining asset.
- A covered combination is an investment strategy that includes consolidating the sale of an out-of-the-cash call and put with a similar expiration dates.
- In spite of the fact that they might earn more premium income, investors really do expect a greater risk of expanding their position in the stock should its price decline below the strike price.
- Investors who utilize this strategy might receive premium income through the sale of both the call and put.