Covered Combinations

Definition

The term covered combination refers to the simultaneous sale of an out-of-the-money covered call and secured put.  Covered combinations can be used by investors that already own the securities or the securities can be purchased when the contracts are written.

Explanation

As the name implies, covered combinations involve two options:  the sale of an out-of-the-money covered call, and the sale of an out-of-the-money secured put.  Investors might consider this strategy if they believe a stock is going to increase in price over time, they wish to increase a return on a covered call, or if they're not sure if it's the best time to purchase a stock but they wish to own some shares now and double that amount if the price per share falls.

With a covered combination, the investor sells both a covered, out-of-the-money call, and an out-of-the-money cash-secured put.  The investor receives a premium for writing both contracts.  If the investor owns the underlying securities, and the price of the securities increase, the shares owned will cover the call.  If the price of the securities decrease, then the cash secures the put, if assigned.  With a covered combination, there are three possible outcomes:

Share Price Increases

If the stock's price rises above the covered call's strike price, the investor will likely be assigned and they will be obligated to sell the shares at the strike price.  The secured put, which has a lower strike price, will expire out-of-the-money.  Overall, the investor's net selling price for the shares will be the strike price on the call plus the two premiums collected for writing the contracts.

Share Price Declines

If the stock's price declines below the secured put's strike price, the investor will likely be obligated to purchase shares with the cash in their brokerage account.  The covered call, which has a higher strike price, will expire out-of-the-money.  In this example, the investor's net selling price for the stock is the strike price on the put minus the two premiums collected for writing the contracts.

Share Price Falls Between Contracts

If the underlying stock closes between the strike price of the call and the strike price of the put, both options will expire out-of-the-money. In this example, the investor gets to keep the two premiums collected for writing the contracts.  This effectively lowers the cost basis for the shares owned, which lowers the investor's breakeven point.

Related Terms

cash-secured puts, protective puts, index puts, Buy-Write Index