Covered Combination

[Igor 10]

Traders who implement a covered combination strategy are betting that the market price will go up for the assets owned in their portfolio. The technique involves writing (selling) the same number of call and put options for shares owned of an underlying asset. Traders gain limited premiums when the market rises, but they expose themselves to unlimited loss risk when the market value of the option's underlying asset falls.

 

The Differences Between ITM, ATM and OTM for Puts and Calls

There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important because of the risks involved in when the market declines and when assigning assets.

 

Put Options:

ITM - In The Money: The underlying asset's market price is less than option's strike price.

OTM - Out of The Money: The underlying asset's market price is more than option's strike price.

 

Call Options:

ITM - In The Money: The underlying asset's market price is more than option's strike price.

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.

 

Both Put and Call Options

ATM - At The Money: The underlying asset's market price equals the option's strike price.

 

 

How to Implement a Covered Combination Strategy (OTM)XYZ is worth $52 (market price)

1) Trader buys 100 shares of XYZ preferred stock and pays $5200.

2) Trader writes (sells) a put option: XYZJan50($1)

- 100 shares of XYZ stock

- Strike Price $50 (OTM), expiring in 30 days

- Premium Cost of $1

3) Trader writes (sells) a call option: XYZJan55($1)

- 100 shares of XYZ stock

- Strike Price $55 (OTM), expiring in 30 days

- Premium Cost of $1

4) Trader receives $200 in premiums ($100 from the put + $100 from the call)

Total Investment cost: $5000 [$5200 (paid) - $200 (premiums collected)]

 

Result one: XYZ hits $57

a) The put option expires worthless (OTM).

b) The call option is ITM. The call buyer exercises his or her right to buy the writer's 100 shares at $55, and pays $5500 to the trader.

c) The trader makes a total profit of $500 after subtracting the amount received from the call from the total cost of the investment. [$500 = $5500 (received from call) - $5000 (cost to enter market)]

 

Result two: XYZ hits $45

a) The call option expires worthless (OTM).

b) The put option is ITM. The put buyer exercises his or her right to sell 100 shares at $50. The writer sells his or her 100 shares in the open market receiving $4500 and adds $500 out of his or her pocket to pay $5000 to the put buyer.

c) The 100 shares received from the buyer suffer a $500 paper loss. [$4500 (current market value) - $5000 (cost of investment)]

d) The trader loses a total of $1000 after adding the amount paid out-of-pocket to the paper loss on shares owned. [$500 = $1000 (paid out-of-pocket) - $500 (paper loss)]

 

Advantage and Disadvantage of Implementing a Covered Combination Strategy:

 

Pluses: The upside to this type of strategy is that the investor will always make a limited profit in a bull market. Another advantage in using a covered combination strategy is that the premiums collected give the trader a discount on the total cost of the investment.

 

Minuses: The downside in using covered combination strategy is that the method limits an investor's profits. Also, if the underlying asset's market value falls, the trader's risk becomes unlimited, as an asset's price can decline to a zero value.