The covered combination is a stock options strategy that can be used when the investor is moderately bullish on a stock or exchange-traded fund.
A covered combination consists holding shares of a stock (a long stock position) while simultaneously holding a short straddle or short strangle options position at the same time. A straddle combines an at-the-money put option and an at-the-money call option. A strangle is a combination of an out-of-the-money put and an out-of-the-money call. Short option positions are used with the covered combination.
A covered combination is assembled by buying stock, then selling a put and a call. The investor should be moderately bullish on the stock and be willing to either sell the stock if it goes above the call strike or buy more if it falls below the put strike.
For a real life example, let's look at General Electric (GE) - Get General Electric Company Report . This is not a recommendation to buy GE, just an illustration. As of Nov. 20, GE was trading at $30.74 per share. The January 2016 32 call was selling for $0.32, and the 30 put was selling for $0.60. So if you bought 100 shares of GE it would cost $3,091. By selling the put and the call you'd receive $92 for a net debit of $2,999. Trading commissions are ignored in this illustration.
If GE closes between $30 and $32 on the Jan. 15 expiration date, both options will expire worthless, and the $92 minus commissions will be yours to keep. If it closes above $32 you'll get called at $32, plus you'll keep both option premiums, so you'll receive $3,292 for a gain of $201 or 6.5% in less than two months. That is your best case scenario. If the stock closes below $30 you'll get assigned on the 30 put and your cost for the 100 shares will be $30 minus the options premiums, which is $2,908. Now you would own 200 shares of GE.
Longer-term options can be used for investors who don't like high turnover. Using the January 2017 LEAPS instead of the 60-day options would look like this: You'd buy 100 shares of GE for $3,091. You'd sell the 30 put for $2.38 and the 32 call for $1.36, for a total of $374. Your break-even will now be $2,717. Your static return, if the stock doesn't move at all, will be just over 12% plus dividends. The current quarterly dividend for GE is 23 cents, so that would be another $92 over the year if GE doesn't cut the dividend. The maximum profit would be about 16% plus dividends.
The process can be continued until you are either called out of the stock or you have accumulated your maximum position. If you are willing to accumulate 1,000 shares of the stock, you could keep repeating the process until you own 1,000 shares or your accumulated position gets called away.
An alternative to starting with a covered combination is to identify a stock that you're willing to own and a price you're willing to pay, and then begin by selling puts until you get assigned. Once you get assigned and are long the stock, then you can sell the strangle against the long stock and build the covered combination. If you're willing to build a 1,000-share position, you can decide how many contracts you want to sell each time. You could plan to execute the strategy with one option contract on each side and accumulate 100-share lots, or 2 contracts, or 5 contracts. One of the beauties of using options is the flexibility and creativity they allow.
The flexibility that options provide allows for adjustments in strike price and expiration date selection. If you're bullish on the stock and want to allow more room for upside profit, you can sell the calls farther out of the money and the puts closer to the money. If you're a little less bullish you can sell the calls closer and the puts further away. For example, if you own 100 shares of stock, you are long 100 deltas. If you create a covered combination and sell a 50-delta put and a 50-delta call, they will offset and you'll still be long 100 deltas. If you're more bullish you can sell the 50-delta put and the 25-delta call, and now your net delta position will be 125 deltas or the equivalent of being long 125 shares of stock. If you're less bullish, you can choose to sell the 25-delta put and the 50-delta call, and that would be equivalent of owning 75 shares of the underlying stock.
The options you sell don't have to be from the same expiration either; you can choose to sell the put and the call with different expiration dates, which can be a useful strategy for planning around earnings announcements and ex-dividend dates.
Remember, options involve risk. It's important to understand how they are priced and know your personal risk tolerance; they are not suitable for all investors. In this example I illustrated a single stock, but you can also use this strategy on a broad-based index ETF to eliminate individual stock risk.
This article is commentary by an independent contributor. At the time of publication, the author held a long position in GE.