Covered Combination


Head of Product Strategy for OptionsPlay


A covered combination is an often-overlooked options strategy by many investors who may utilize each half of the strategy separately, but never considered combining them. This is a strategy where an investor owns 100 shares of a stock and sells a covered call and a cash secured put at the same time. The motivation for this strategy is to maximize income by collecting two sets of premiums – from selling a Covered Call, and the cash secured Put. The tradeoff for the increased income is that the investor must be willing to purchase additional shares of the stock to sell the cash secured put. Another way to understand this strategy is to think of it as selling a strangle on a stock position that you own. To better understand this strategy, having experience with both Covered Call and Short Put strategies are essential to utilize the Covered Combination strategy. 

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 typically be 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 repeating the strategy for additional income. However, should the underlying rally above the strike price and the option is exercised, the call writer is obligated to sell the shares that they own at the strike price to the option buyer. 

Review of Short Puts

The Short Put strategy is an income generation strategy that involves selling a put option with a strike price lower than the underlying’s current price. By writing/selling a put option, the seller receives a premium or income. Short Puts are also typically 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 neutral to bearish view but long-term bullish view of the stock. If a stock declines below the strike price at expiration, a put seller will be obligated to purchase the stock 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 the strike price minus premium received per share. If the stock does not decline below the strike price, the put seller will simply keep the premium and have the option of selling another put. 

The Covered Combination Strategy

The Covered Combination strategy utilizes both the Covered Call and Short Put strategies at once. 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 premiums for selling the Covered Call and the Put option (strangle) simultaneously. 

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 $128

Covered Combination Strategy:

  •       Buy 100 shares of BMO at $128 
  •       Sell 1 BMO Aug $130 Call @ $1.75
  •       Sell 1 BMO Aug $125 Put @ $2.25

Chart 1: BMO Covered Combination

BMO Covered Combination

Source: OptionsPlay

In this example, the investor receives a total premium of $4.00 (3.1%) per share from writing the call and put options. At expiration, if BMO is trading:

  • Above $130 – the call option is exercised by the buyer and the seller will need to sell 100 BMO shares at $130 per share. However, the investor keeps the $4.00 premium per share. The net selling price is equal to the strike price + premium: $130 + $4 = $134.00 per share.
  • Below $125 – The put option is exercised and the option seller will need to purchase 100 shares of BMO at $125 per share. Again, the investor keeps the $4.00 premium per share. The net purchase price for the share is equal to the strike price – premium: $125 – $4 = $121.00. The investor will now own 200 shares of BMO.
  • Between $125 and $130 – Both the call option and the put option will expire worthless and the investor keeps the $4.00 of premium and has the option of selling another covered combination to collect further income. 

The maximum gain for this strategy is the sum of the two premiums received. However, if the stock were to decline below the short put strike price, an investor needs to factor into the additional shares that they now own into the risk calculations.  

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 has 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 income received will be less. For investors seeking 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. In this case, selling a 16 Delta call and put would be a suitable starting point to research opportunities.

However, if the investor wants to prioritize purchasing more stock, a more suitable strategy would be to sell a higher Delta put (40 Delta) and a Lower Delta (16 Delta) call. The higher Delta put will receive more premium and has a higher probability of being assigned to purchase the shares. For the call option, the 16 Delta call would provide a long-term bullish outlook on the stock and will only be assigned up on a strong rally of the underlying. 

In summary, the Covered Combination is a way to maximize income generation while potentially acquiring more stock or selling a portfolio holding after a significant rally to take advantage of the capital appreciation. A strong understanding of selling Covered Calls and Short Puts individually will be helpful towards executing this strategy in your portfolio. 

Originally Posted on September 28, 2021 – Covered Combination

Dollars expressed are in CAD


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