Introduction

The Covered Combination strategy is a strategy where an investor owns 100 shares of a stock and sells a call option and a put option. This strategy combines the Covered Call and Short Put strategies into a single strategy. The motivation for this strategy is to collect two sets of premium - from selling a Covered Call, and selling a Put option. The investor should also be open to the idea of owning additional shares of the stock in the event that the underlying declines considerably. A good understanding of the Covered Call and Short Put strategies are essential for investors looking to utilize the Covered Combination strategy. 

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Review of Covered Calls

The Covered Call strategy is an income generation strategy that involves selling an "out of the money" call option on a stock that is already owned by the investor. The prerequisite to this is that the investor owns a minimum of 100 shares of the underlying stock. Selling a call option results in a premium that is collected by the investor. The short call option will have a strike price that is higher than the current price of the underlying stock. Typically, this strategy is a neutral strategy as the investor selling the call option would want the option to expire worthless, resulting in the call seller keeping all the premium and rinse and repeat the strategy. However, should the underlying rally to the strike price and the option is exercised, the call writer is obligated to sell the shares that he/she owns at the strike price to the option buyer. The profit potential of this strategy is the premium received by the option seller plus the strike price of the option (in the case of exercise). 

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Review of Short Puts

The Short Put strategy is an income generation strategy that involves selling a put option where the strike price is lower than the underlying's current price. The option seller is obligated to buy the shares at the strike price from the buyer of the put option in the event that the put contract is exercised. By writing/selling a put option, the seller receives a premium. Short Puts are also used as a stock acquisition strategy. This is because the put seller is obligated to buy the stock at the strike price (which would be lower than the price of the underlying at the time of selling the put). As a stock acquisition strategy, Short Puts should be used when the investor has a short term bearish but long-term bullish view of the stock. An investor wanting to acquire the stock at a discount will want the stock to decline below the strike price so they are obligated to buy the shares at the strike price. In addition, because the put seller is receiving a premium for selling a put option, the effective cost of each share purchased is actually the strike price less premium received per share. If the stock does not decline below the strike price, the put seller still receives the premium.

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The Covered Combination Strategy

The Covered Combination strategy utilizes both the Covered Call and Short Put strategies into one. This strategy requires the investor to own 100 shares of the underlying stock already. There are 3 motivations to use the Covered Combination strategy:

1. Purchase more shares - the Short Put strategy allows the investor to purchase additional shares below the current market price should the put contract be exercised. 
2. Sell shares above current market price - The Covered Call aspect of this strategy allows the investor to sell the stock at the strike price if the underlying stock rallies above the Covered Call strike. 
3. Income generation - the investor receives two "sets" of premium for selling the Covered Call and the Put option. 

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Because the Covered Call strike is greater than and Short Put strike is less than the underlying's current price, there are 3 possible outcomes at expiration:

• Underlying rallies above Covered Call strike - the investor is obligated to sell 100 shares of the underlying at the strike price of the call option.  
• Underlying declines below Short Put strike - the investor is obligated to buy 100 shares of the underlying at the strike price of the put option.
• Underlying remains between both strikes - the call and put expires worthless. Investor simply keeps the premium received from selling both contracts. 

Consider the following example

$BMO trading at $100

Covered Combination Strategy:

• Buy 100 shares of $BMO at $100 (unless already included in portfolio)
• Sell 1 $BMO $110 Call @ $3.00
• Sell 1 $BMO $90 Put @ $3.00

In this case, the investor receives a total premium of $6.00 per share from writing the call and put options. At expiration, if $BMO is trading:

• Above $110 - the call option is exercised by the buyer and the seller will need to sell 100 $BMO shares at $110 per share. However, the investor still keeps the $6.00 premium per share. The net selling price is equal to the strike price + premium: $110 + $6 = $116.00 per share.
• Below $90 - The put option is exercised and the option seller will need to purchase 100 shares of $BMO at $90 per share. Again, the investor keeps the $6.00 premium per share. The net purchase price for the share is equal to the strike price - premium: $90 - $6 = $84.00. The investor will now have 200 shares of $BMO.

The maximum gain for this strategy is the sum of the two premiums received. The maximum loss happens if $BMO declines to $0. The maximum loss is calculated as follows: stock purchase price + put strike - net premiums received. In the example above, the maximum loss is $100 + $90 - $6 = $184.00 per share. 

The Optimal Covered Combination

The best practice for this strategy is to sell options with roughly a 45-day expiration. The strike selection is dependent on the motivation or goal for the investor. By selling a Covered Call or a Short Put that have strikes closer to the current price, the investor will receive more premium, but there is a higher probability of assignment. Strikes that are further away from the current price will have a lower probability of being assigned, but the premium received will be less. For investors looking to maintain their stock holding and only seek income generation, further "out of the money" strikes should be used. While this may yield less premium than strikes that are closer to the underlying's current price, there is a lower probability of being assigned which means that the investor can simply rinse and repeat this strategy without having to buy more shares. In this case, selling a 15 Delta call and put would be advisable. 

However, if the investor has a long term bullish view on the stock and does not mind acquiring more shares, a more suitable strategy would be to sell a higher Delta put (45-40 Delta), and sell the 15 Delta call. The higher Delta put will receive more premium than a lower Delta put and has a higher probability of being assigned where the investor is obligated to purchase the shares. For the call option, the 15 Delta call should still be used as the investor has a long term bullish outlook on the stock and does not want to sell after a small rally. 

In summary, the Covered Combination is a powerful income generation strategy that can also be used to acquire stock at a discount or sell stock after a significant rally to take advantage of the capital appreciation. A good understanding of selling Covered Calls and Short Puts is needed for this strategy as it involves selling options which may be assigned. 

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