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The Covered Combo

Key Points
  • Covered calls are often used to generate income, or to set a selling price on a stock you already own.

  • Cash Secured Equity Puts (CSEPs) are often used to generate income, or to set a purchase price on a stock you’d like to own; or that you’d like to own more of.

  • A covered combo merges these two strategies. 

  • A covered combo can help increase your profit, derive additional income, and lower your cost basis. 

If you're like most investors, you probably have positions in your account that you've held for a long time. But, that doesn't mean that if the price was right, you wouldn't consider selling a few shares and taking some profits.

After all, unless your goal is strictly to get dividends, you probably bought stocks that you hoped would go up so you could eventually sell them at a profit. On the other hand, if you consider these positions part of your “core” holdings, you might also be perfectly content to hold them for many years.

As an experienced investor, you’ve probably been through plenty of uptrends and downtrends in the market, and you probably know that when the overall market pulls-back, even good stocks get pulled down. And when that happens, it can be an opportune time to add to your positions when prices are low.

What's a covered combo?

Imagine a strategy that would let you specify the price at which you would be willing to sell some shares and a price at which you'd be willing to buy more shares, both at the same time. Even better, imagine if you got paid just for being willing to commit to those two price levels for a certain period of time. Let me tell you about an innovative option strategy that can do this—it’s called a covered combination trade or simply, a Covered Combo.

A covered combo is the simultaneous sale of both a covered call (out-of-the-money) and a cash-secured put (out-of-the-money), both with the same expiration month.

While option strategies (especially multi-leg strategies) often have interesting names, "covered combo" is admittedly a bit of a misnomer. With a covered combo, your upside is covered by stock but your downside is only "covered" by cash. This is typically referred to as “cash secured,” but it is not really covered. Nomenclature issues aside, the strategy has a lot of merit if your investment style is consistent with the description above.

How does it work?

Let's start with an example. Assume you own 400 shares of XYZ with an original purchase price of $100 per share. Consider these two points:

  • You believe XYZ is a good long-term investment but because 110 has been somewhat of a resistance level for the past 12 months, if the price increases to about 110 per share again, you would be willing to take some profits by selling half of your position.
  • On the other hand, because you like XYZ long-term, you would also be willing to add another 200 shares to your position if it drops back down near its lowest point of the past year (87.50 per share), which appears to be somewhat of a support level.

Source: StreetSmart Edge.

One way to set both an entry and exit price would be to use two limit orders. Good-til-canceled limit orders would allow you to enter a buy order for 200 shares at 87.50 and a sell order for 200 shares at 110, and they would remain active for 60 days. Limit orders don’t cost anything to enter, but they also don’t generate any income. Alternatively, you could use a covered combo which generates two option premiums; one for the call and another for the put, but otherwise acts very similar to the two limit orders.

Since you already own the underlying stock, you can enter a covered combo using the strangle order-entry screen in StreetSmart Edge. As you can see in this example below, if this order is entered at a credit of 2.00, you will receive $400 (2.00 X 200 shares) when this order is executed. (This example uses options with approximately 60 days until expiration.)

Entering a covered combo on the strangle screen

Source: StreetSmart Edge.

This $400 credit isn't free money. Option strategies are usually about making tradeoffs, and this is no exception. Once this order is executed, you take on a couple of obligations that you'll have to meet if the stock increases or decreases significantly in price.

If XYZ increases to 110 per share or more

The sale of the two Jan 110 calls is covered by 200 shares of XYZ stock that you already own. If XYZ increases in price above 110 by January 18, 2019, you will have your shares called either prior to, or at expiration. This would result in a profit of $10 per share (or $2,000) on the 200 shares of stock that is called away, and if XYZ continues to increase in price, you still own the other 200 shares that will keep gaining value.

If XYZ is above 110 per share, not only would you make $10 per share on 200 shares, but you also get to keep the $400 that you originally brought in when you sold the covered combo. At any price above 87.50, the two 87.50 puts would expire worthless. That actually makes your profit on the assigned shares equal to $12.00 per share or $2,400. This is almost like selling your stock at 112, but it only has to reach 110 for it to happen.

Another way to look at this is that after expiration you effectively end up with a position of 200 shares of XYZ at a net cost basis of only $88.00. This is calculated as follows:

  • Original purchase: 400 XYZ @ 100/share = -$40,000
  • Proceeds from combo: 2.00 x 2 x 100  = +$400
  • Proceeds from assignment: 200 x 110 = +$22,000
  • Overall net cash outlay:  -$17,600
  • Divided by remaining shares owned:  ÷200
  • Net cost basis: $88.00 per share

If XYZ drops to 87.50 per share or lower

If XYZ drops sharply, because you also sold two Jan 87.50 puts, you would have been required to secure that sale with enough cash to cover the cost of assignment, should that occur. If XYZ drops below 87.50, you will be assigned prior to, or at expiration. This assignment would cost you $17,500 (87.50 x 200) and you would also be down an additional $5,000 ((100 – 87.50) x 400) on the original 400 shares of XYZ that you already own.

That's the bad news, but it isn't quite as bad as it may seem. If XYZ is below 87.50 at expiration, while you would pay $17,500 to buy 200 additional shares, the 110 calls you sold will expire worthless and you get to keep the $400 that you originally brought in when you sold the covered combo. At any price below 110, the two 110 calls would expire worthless. That effectively makes your cost basis 83.50 per share (87.50 – 4.00) on the 200 shares you just bought. So even though you get assigned below 87.50, you would not actually end up with a loss on the 200 new shares unless the stock was below 83.50.

Another way to look at this is that after expiration you effectively end up with a position of 600 shares of XYZ at a net cost basis of only $95.17. This is calculated as follows:

  • Original purchase: 400 XYZ @ 100/share = -$40,000
  • Proceeds from combo: 4.00 X 2 X 100 = +$400
  • Cost of assignment: 200 x 87.50 = -$17,500
  • Overall net cash outlay:  -$57,100
  • Divided by total shares owned:  ÷600
  • Net cost basis: $95.17 per share

If XYZ stays between 87.50 and 110 per share

The third possible scenario is that XYZ is between 87.50 and 110 at expiration. If that occurs, both the calls and the puts would expire worthless and you would get to keep not only the $400 you received when you sold the combo, but also your original 400 shares of XYZ; only now your new cost basis is 99.00, calculated as follows:

  • Original purchase: 400 XYZ @ 100/share = -$40,000
  • Proceeds from selling the combo: 4.00 x 2 x 100 = +$400
  • Overall net cash outlay: -$39,600
  • Divided by total shares owned: ÷$400
  • Net cost basis: $99.00 per share

There is a lot going on in this strategy, so let's look at it in a table:

Source: Schwab Center for Financial Research.

As the table shows, while you could just hold onto your stock and use simple limit orders to enter your limit prices, using the covered combo results in a lower overall cost basis in all scenarios.

Consider what would happen at the following stock prices:

  • If the stock is at 110 or above at expiration, you'll end up selling half your shares at a very favorable price, and that results in a net cost basis on your remaining 200 shares that is $2.00 lower than it otherwise would have been.
  • If the stock ends up between 87.50 and 110, where it has spent the vast majority of its time during the previous year, you will retain your entire 400 share position, but with a net cost basis that is lower by $1.00 per share.
  • If XYZ drops to 87.50 or below, you will increase your share size to 600 and your risk will go up by $17,100, but the effective net cost basis on your entire position will be $0.67 per share lower than if you had used a limit order.   

Alternative example

A covered combo can also be entered as a single transaction, where instead of owning the stock ahead of time, the stock position can be purchased at the exact same time the covered calls and cash secured puts are sold. You can enter this 3-legged order using the Custom order-entry screen in StreetSmart Edge. After execution, all of the scenarios above still apply.

Entering a covered combo on the custom screen

What are the risks?

While the covered combo has many positive characteristics, like all option strategies there are risks that should not be overlooked:

  • Although the premium received from the sale of a covered combo provides some downside risk protection, it does not eliminate risk entirely.
  • If the price of the underlying stock drops substantially prior to the expiration date, you will put additional capital at risk and your losses could be significant.
  • If either your short calls or short puts go in-the-money, you could be assigned at any time.
  • Anytime you sell a covered call, you have established a maximum selling price for your stock. Any movement in the stock beyond that established price creates no additional profit on those shares.
  • It is rarely a good idea to sell a covered call if your stock position has already moved significantly against you. Doing so could cause you to establish a closing price that ensures a loss.
  • While the examples above assume that you hold the position(s) until expiration, you can usually close out a covered calls, the protective puts (or both) at any time by buying them back to close at the current market price.

Bottom line

If you have core holdings in your account and there are prices at which you'd be willing to sell some or buy more, consider a covered combo and get paid while you wait.

For additional information on covered combos or for assistance with other options strategies, please contact a Schwab Trading Specialist at 800-435-9050.

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 1-800-435-4000 for a current copy.

Multiple-leg options strategies will involve multiple commissions. Writing uncovered options involves potentially unlimited risk. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Schwab does not recommend the use of technical analysis as a sole means of investment research.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
Past performance is no indication (or "guarantee") of future results.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.

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