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 $50 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.
Next live seminars
Phoenix, Arizona area:
1- Phoenix Point Options Group
January 9, 2015: Tempe, AZ: 7:00 – 9:00 PM
Link is above…scroll down.
2- American Association of Individual Investors- Phoenix Chapter
January 10, 2015: Scottsdale, AZ: 9 AM – 12PM and 1:15 PM to 2:30 PM
http://www.aaii.com/localchapters/pdfs/Phoenix%20150110.pdf
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
Happy holidays to one and all,
Alan (alan@thebluecollarinvestor.com)
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 12/19/14.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The BCI Team
Alan,
You may wish to review two items on this blog.
I think you intended to write Outcome if share price closes below $50 at expiration rather than Outcome if share price closes below $55 at expiration.
Also for Outcome if share price closes between $50 and $55 at expiration
I was under the impression that both premiums would be taxed as short term capital gains in the current tax year and the existing cost basis would then be unaffected since tax would have to be paid on the expired contracts.
Gene,
Thanks for pointing out the typo…it’s been corrected.
Tax: I prefer our member to contact their tax advisors when it comes to these issues but my understanding is the same as yours…short-term capital gains if trading outside of sheltered accounts. The cost basis offered in this article is for purposes of calculations and broker requirement for securing put trades. Please contact you tax advisor for all tax-related issues. In my books, tax chapters were written by a CPA/attorney.
Thanks again for finding the typo. I’ll put in a good word with Santa.
Alan
Hi Alan
Firstly, I am particularly concerned that if the price falls way below our cost basis, thereby producing substantial loss in trading.
Let’s imagine that we have a loss of $2.00 per contract, or $400 for 200 shares. One option we have is to write another covered call on these shares until we reach a stage where we get back our investment.
This would be the method of an income investor, however, how do you think the other investors who look at the growth of the portfolio view this scenario?
Would your advice be to ensure that each trade generates profit, and cut loss’ if the stock establishes down trend?
Majority of us have difficulty at being an income investor exclusively, whereas most us look for the growth. I would be interested in your views on this.
Secondly, what are your views on doing necked OTM call and cash secured put, giving a strangle? Of course, the outcome( of result of market moving up and down) that you have painted above will still hold.
Many thanks
Sean
Hi Sean,
You are concerned about the right scenario. A drop in price of the underlying security is what we, as cc writers or put sellers (or long stock owners for that matter), need to be prepared for. In my new book, I lay out position management techniques for all scenarios, both positive and negative.
Selling put and call options are income-generating strategies with the possibility of a growth component in normal and bull market conditions. That’s where mastering the skill of strike price selection comes into play. Whenever possible, we try to get both but in certain bearish or volatile market conditions we are better served concentrating on only income. This is an art as much as a science.
It is important to define our goals and then focus like a laser on achieving those goals without the distraction of another strategy that may have other objectives.
Using strangles is a strategy that looks for large price movements in the underlying securities and is beyond the scope and mission statement of this site.
Alan
Premium Members,
The Weekly Report has been revised and uploaded to the premium member, website. There was a typo with HAWK…it has now been corrected…HAWK reports in the current option month.
Please download the report dated 12/19/14-REVA. A thank you to Emily for noticing the typo.
Best,
Barry
Premium Members,
The Weekly Report has been revised and uploaded to the premium member website. There was a typo with MCK on the Running List…it has now been corrected.
Please download the report dated 12/19/14-REVB. A thank you to Park for noticing the typo.
Best,
Barry
Alan,
I see where T has paid it’s dividends for 133 years. Is that a typo? So that means it started back in 1891. Sell it’s leaps you would go out to 1/16. I have to check the tables.
Best,
Richard
Richard,
Yes, that is accurate. AT&T has been paying dividends since the late 1800s. here’s an excellent free site to get dividend info:
http://www.dividendinvestor.com/?chk=329d81419269434&symbol=t&submit=GO
Alan
Congratulations to new member Rodrigo on his 1st month’s returns. CLICK ON IMAGE TO ENLARGE & USE BACK ARROW TO RETURN TO BLOG.
Keep up the good work.
Alan
If I sell a covered call in the money and it exercises. Still make money on it from the options premiums, is this taxed as Capitol gains or a capital loss? If it is taxed as a Capitol loss is this a bad thing? Will this afect how much SSC I get when I retire?
Caleb,
Check with your tax advisor for your specific situation. In general, short and long term capital gains or losses is determined by the holding period for the stock or option. In the case of option-selling, it is almost always short-term in nature. For stocks, if owned for more than 1 year and one day it is long-term. Whenever possible, option-selling should be done in sheltered accounts.
The impact on SS is beyond my area of expertise.
Alan
All PUT Books shipped:
We received a large shipment from the publisher yesterday allowing us to ship all remaining books ordered. The first 2 shipments were sold out in the first 4 days of early-ordering so we had to wait for the publisher to print more books. We now have adequate inventory to ship new orders within 1 – 2 business days of receipt of the order (usually 1 day).
Thanks for your patience in this matter and for your amazing support.
Alan
Premium members:
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
NOT A PREMIUM MEMBER? Check out this link:
https://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team