A Covered combination (“combo trade”) trade is the simultaneous sale of an out-of-the-money (OTM) call and an out-of-the-money put with the same expiration date on 100 shares of a stock or ETF (exchange-traded fund). It consists of a combination of a covered call and a short put position on a share-for-share basis. The investor generates two premiums from the sale of the call and the put, in exchange for taking on the risk of doubling his stock position should the price decline below the strike price of the put by the expiration date.
Recently, we have had several BCI members inquire about this strategy and that is the motivation for this blog. This strategy is appropriate only for investors willing to hold long stock positions in 200 share increments as this article will explain. The motivation for using this strategy is to increase premium returns and to double a stock position half of which can be at a discount (if put is exercised).
Hypothetical covered combination trade
- Buy 100 shares of BCI at $52 per share for $5200
- Sell 1x OTM $55 call at $1.75 (1-month expiration)
- Sell 1 x OTM $50 put at $1.50 (1-month expiration)
- Secure the $50 put sale with a deposit of $5000 into brokerage cash account (broker may allow you to deduct put premium)
Outcome if share price closes above $55 at expiration
This is the outcome that will maximize the returns:
- The put expires out-of-the-money and worthless
- The call is exercised and shares are sold at the $55 strike price
- No shares are owned after expiration
- Total option profit = $325 ($175 + $150)
- Stock profit = $300 (100 x $3) after buying at $52 and selling at $55
- Total profit = $625
- Cost basis is $5200 (buy 100 shares) + $5000 (to secure the put) = $10,200
- 1-month percentage return = $625/$10,200 = 6.1%
Outcome if share price closes below $55 at expiration
This is the worst case scenario and may necessitate the implementation of exit strategy maneuvers.
- Net cost of 100 shares of BCI assigned from put = $50 – $3.25 (two premiums) = $46.75
- Still long 100 shares at a cost basis of $52
- Average cost basis of 200 shares = $49.38
Outcome if share price closes between $50 and $55 at expiration
Both options expire out-of-the-money and worthless
- No option assignment
- Retain 100 shares originally purchased at $52
- Option 1-month return = $325/$10,200 = 3.2%
- Cost basis of the 100 shares is reduced to $48.75 ($52 – $3.25)
Possible outcomes that are part of this strategy
- Obligation to sell 100 shares at $55
- Obligation to buy 100 shares at $50
- Double stock position on the downside
- Early assignment of the call is possible prior to an ex-dividend date
- Early assignment of deep in-the-money puts is possible if the time value approaches zero
Position management
BCI books, DVDs and blog articles have detailed exit strategy opportunities for both strategies and these should be utilized whenever indicated. The fact that covered combinations employ both strategies simultaneously does not eliminate the critical importance of position management to mitigate losses and enhance gains.
Discussion
I wrote this article in response to member inquiries. I am not necessarily encouraging the implementation of covered combinations but rather presenting an overview for those who are considering its use. There are many ways to make money in the stock and option markets and education is the tool that will maximize those returns.
Beware of the VIX
Despite the market increases this week, I am inclined to take a more conservative stance in my portfolio for the January contracts because of the sharp movement of the VIX (CBOE Volatility Index also called the investor fear gauge). Generally, the VIX and the S&P 500 are inversely related so an increase in market volatility may enhance our option profits, but it also represents more risk incurred. For most of us, this is not a positive. The chart below reflects this inverse relationship and shows the 3 large spikes in the VIX during the past 6 months. I am still encouraged by our markets, just taking a short-term defensive stance:
The inverse relationship between the VIX and the S&P 500
Market tone
The market seemed to forget all its global concerns when the Fed announced its intention for no interest rate hike for a “considerable time” It appears that short-term interest rates will continue to be held to near zero at least through mid-2015.Here are this week’s reports:
- Industrial production in November rose by 1.3%, nearly double the 0.7% expected by analysts
- According to the Labor Department, the Consumer Price Index (CPI) declined by 0.3% in November, the largest decrease in the past 6 years. This had everything to do with the dramatic drop in oil prices
- In the past year, the CPI rose by 1.3%, below the 2% target rate set by the Fed
- New residential construction dropped by 1.6% in November from October stats. However, November figures reflected the first time in 6 years that new housing starts exceeded 1 million for 3 consecutive months
- The Conference Board’s index of leading economic indicators in November increased by 0.6%, better than the 0.5% projected by economists. This was the 6th increase in the last 7 months. In addition, the board reported signs of wage growth
For the week, the S&P 500 increased by 3.4%, for a year-to-date return of 14%, including dividends.
Summary
IBD: Market in correction
GMI: 5/6- Sell signal since market close of December 15, 2014
BCI: Cautiously bullish due to the severe swings in the VIX, selling equal numbers of in-the-money and out-of-the-money strikes. Selling out-of-the-money puts is another way to navigate unusually volatile markets
Wishing you the best in investing,