The Covered Combo
Len Yates

In tumultuous markets you would think there would be abundant options trading opportunities.  Turns out, it’s not that simple.  In such an environment the options are very expensive.  That would suggest finding a way of selling them, but what is a good, safe way of selling them?  Covered writing is okay, but it leaves you holding the bag in a swift decline.  Naked writing is even more dangerous in a volatile environment.

Question:  Would you like to pick up some good stocks just below current price levels?  If your answer to that question is yes, you might want to consider the covered combo.

The covered combo strategy consists of a covered write (long stock and short call) plus a short put.  In order to receive some good premium and downside protection, an at-the-money or just out-of-the-money call is typically selected to form the covered write.

The put is typically selected at a strike below the current stock price, presumably at a price where you would be happy to buy more shares of this stock.  Technically this short put is a naked option.  However, it’s not a dangerous option.  If the stock falls below the put’s strike price you may be assigned, thus buying more shares.  You simply need to be prepared to do this.

Since the covered combo has you selling options, this strategy takes full advantage of currently inflated option prices.  In a volatile market, literally hundreds of stocks can be ripe for covered combos.  The key is to pick a stock you’d like to own, or perhaps one you own already.  Then figure out how many shares to buy (if any) and which calls and puts to sell.

Let’s use a hypothetical example, a stock called XYZ Group currently trading at $70.00 a share.  Not only is implied volatility (IV, represented by the blue line) at very high levels relative to its past history, it is higher than the actual volatility of the stock (SV, represented by the red line).  This means its options are both expensive and overvalued.

Covered Combo 1

The following covered combo, using options that will expire in 47 days, might be considered:

Buy 100 shares of XYZ Group      at 70.00
Sell 1 February 75 Call          at  3.40
Sell 1 February 65 Put           at  3.15

Let’s analyze this trade.  With the stock at 70.00, the proposed out-of-the-money call sale would give us 3.4 points of downside protection.  In other words, the stock could drop to 66.60 before we incurred a loss.  These expensive options give us a lot of downside protection!

Then add to that the credit received from selling the puts.  Regardless of where the stock price goes, the extra 3.15 points received from selling the puts can be considered as helping us buy the original 100 shares of stock for 3.15 points less.  Considering the proceeds from the puts and the calls together, we’re effectively buying the stock for approximately $63.45.  That’s $6.55 below the current market value!

If the stock does fall below $65.00, our then in-the-money puts would probably be assigned, and we’ll be buying an additional 100 shares of stock at $65.00.  So the first 100 shares cost us $63.45 each.  The second 100 cost you $65.00 each.  That means we would get 200 shares at an average price of $64.255.  Not bad when you consider that the current price of the stock is $70.00!  Magic!

So what’s the catch?  The catch is that if the stock continues to fall, we’re losing $200 per point on our 200 share stock position.  But presumably this was an acceptable risk for us as willing stock investors.  The initial trade cost $7,601 (not using margin on the stock) and if instead the stock soars, we make $1,117 and no more, as our upside gains are capped by the short calls.  Here is a picture of the XYZ Group covered combo:

Covered Combo 2

The software assumes this high volatility will continue in its projection of possible future stock price behavior, and still calculates a probability of profit of 68%.  Even if the stock price is still at $70 come the February expiration day and the options expire worthless, this investment yields an attractive 8.1% in just 47 days (63.1% annualized).

Interestingly, the graphic analysis does not show what happens in all circumstances.  It is conservative.  It only shows what happens if the stock goes straight from its current price to other prices represented along the horizontal axis.  If the stock drops to 65 and you get assigned an extra 100 shares, and then the stock goes back up, your outcome is better than the graph depicts – much better.