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Covered Combination
The covered combination, also known as the covered strangle, is a limited profit, unlimited risk strategy in options trading that involves selling equal number of out-of-the-money calls and puts of the same underlying security, strike price and expiration date while owning the underlying stock.
Limited Profit Potential
Maximum gain for the covered combination is achieved when the underlying stock price on expiration date is trading at or above the strike price of the call options sold. This is the price where the trader's long stock gets called away for a profit plus he gets to keep all of the initial credit received when he entered the trade.
The formula for calculating maximum profit is given below:
- Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid
- Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Unlimited Risk
Large losses can be experienced when writing a covered combination when the underlying stock price makes a strong move downwards below the breakeven point at expiration. This strategy loses money twice as fast as a regular covered call write as the covered combination loses not only on the long stock position but also on the short put.
The formula for calculating loss is given below:
- Maximum Loss = Unlimited
- Loss Occurs When Price of Underlying < (Purchase Price of Underlying + Strike Price of Short Put - Net Premium Received) / 2
- Loss = Purchase Price of Underlying + Strike Price of Short Put - (2 x Price of Underlying) - Max Profit + Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the covered combination can be calculated using the following formula.
- Breakeven Point = (Purchase Price of Underlying + Strike Price of Short Put - Net Premium Received) / 2
Example
Suppose XYZ stock is trading at $52 in June. An options trader executes a covered combination strategy by selling a JUL 50 out-of-the-money put for $100 and a JUL 55 out-of-the-money call for $100 while purchasing 100 shares of XYZ for $5200. The total premiums received for selling the options is $200.
On expiration in July, if XYZ stock rallies above the strike price to $57, the JUL 50 put expires worthless while the JUL 55 call expires in the money and the 100 shares get called away for $5500, producing a gain of $300 on the long stock position. Including the $200 in premiums received upon entering the trade, the total profit comes to $500 which is also the maximum profit attainable.
However, if the stock price drops below the breakeven to $45, the JUL 55 call expires worthless but the naked JUL 50 put and long stock position suffer large losses. The short JUL 50 put is now worth $500 and needs to be bought back while the long stock position has lost $700 in value. Factoring in the $200 premiums received earlier, the total loss comes to $1000.