Covered Combos Options: 3 Ways to Trade Covered Combos
A Covered Combo is built by combining two other separate and distinct strategies: the covered call and the strip option.
You write, or sell, a call option against 100 shares you own (the covered purchase portion of the transaction) and receive cash (the premium) in exchange for giving someone else the right, but not the obligation, to buy his actions. from you at a specified price (strike price) before a specified date (expiration date). You then write, or sell, a second option, this time a put option (i.e. a bare put option) that, for another cash premium, gives someone else the right to sell you 100 shares of the same stock. at a certain price on a certain date.
Depending on where the shares close at expiration, you may need to sell the initial 100 shares you own (if the shares close above the call option strike price) or be required to buy an additional 100 shares (if the shares close for below the put option strike price). If the stock ends somewhere between the two strike prices, both options expire worthless, you keep the premium and can repeat the trade with a new expiration date.
Although the description above details the basic construction of the covered combo, a merchant can make slight modifications based on their goals.
Here are three of these tweaks to trade:
- Write the strike prices further. By having two sources of premium income instead of one, the covered combo writer can write both options at strike prices a little further than the trader who writes just one covered call or just one strip option and still receive a comparable amount of premium income. The advantage here is the increased chances of options expiring worthless while maintaining a decent income stream.
- Write the strike prices near or in the money. This is one way to maximize income. If you own 100 shares of a stock that is priced very close to or at which you can simultaneously issue both a covered call and a short sale at the same strike price, you will receive the maximum amount of time premium. As long as the shares are traded at or above the strike price, your profit will be the full amount of the premium received. Note: Due to the large amount of premiums received, the trade offers limited downward protection. But this protection may not be as great as it initially appears. If the put option is exercised and you are required to purchase an additional 100 shares of the stock, the cost basis for that share may be reduced by the full amount of the premium received from both the put option and the call option. That may seem like a significant protection, but keep in mind that in situations where the price of shares goes down, the value of the initial 100 shares you own also goes down in value.
- Write only one leg at a time. There is no requirement that a covered combo must be built in one go. You may find it advantageous to build the different components of the strategy at different times based on the performance or behavior of the stock. A versatile trader, for example, might start with a covered call and only later, perhaps if the stock is trading at a lower level that the trader has identified as a strong support level, add the bare sell part of the trade. .
It is important to understand that the covered combo is actually two different strategies and operations rather than one. The shares you own produce only one source of premium income (the hedged option). The income you receive from the put option is funded or guaranteed (either in whole or in part) by the cash in your margin account. Still, the trade can be intriguing and, in the right situation, can offer some attractive returns.