Who Should Consider Using Covered Combinations?

An investor who is moderately bullish on a particular stock. A covered call writer who is looking for a strategy that might help enhance his

return further.
An investor who would like to buy a particular stock but is not quite sure whether

this is the best time to buy. He might be interested in buying only half of the position now and the remainder on a pullback. The Covered Combination is a strategy that allows the investor to receive premium income in exchange for being willing to double his stock position in the event of a downward price move, enhance his rate of return on the upside, and lower his breakeven price in a static market. Although the covered combination may not be suitable for every investor, anyone who has invested in stocks or covered call writing might want to consider selling a covered combination. The call portion of the combination could be written against stock that is already owned at the time the combination is written. Selling a cash-secured put involves selling a put and depositing the money for the purchase of stock at the investor's brokerage firm (generally, this is invested in short-term instruments). The purpose of having the money in a brokerage account is to assure that the funds are available to purchase the stock should the put be assigned to the investor's account. The buyer of the put will generally exercise the option only if the underlying stock falls below the strike price. If the stock declines below the strike price, the investor is obligated to purchase the stock at the put strike price no matter how low it has declined. In other words, when writing a covered combination, the underlying stock is held at the same time that both puts and calls are sold. By selling both puts and calls, two premiums are received to lower the cost of the position. If the stock does not move to the strike prices by expiration, the benefit of both premiums is retained. New puts and calls could be sold as long as the investor's outlook on the stock has not changed. If the stock rises above the call strike the investor will be obligated to sell the stock at the

Definition
A covered combination is simply the sale of a covered call and a cash-secured put. Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held. The writer is obligated to sell the stock should the call be assigned. Generally, the call will be assigned only if the price of the underlying stock rises above the strike price.

strike price, but remember, the breakeven was lowered by the two premiums that the investor received. If the stock drops below the put strike, the investor will be assigned and the stock will have to be purchased, but once again two premiums were brought in to offset some of the stock cost. In other words, the investor will be paid to accept the obligation to double the number of shares of a stock that he is willing to own. If this happens, he could then continue to sell calls and bring in additional premium.

I. ZYX is above 55 at expiration. The put options will expire worthless and the investor will be assigned on his call options. In other words, ZYX will be called away and the investor will have to sell the stock at 55. However, he has received two option premiums for having sold the puts and the calls. Purchase Stock Less Call Premium Less Put Premium Breakeven Price (or Net Cost Per Share) 51-1/4 -2.25 -2-1/4 46.75

Goal: Increase Returns or Double Your Stock Position

Lets take the example of an investor who would like to buy 1,000 shares of ZYX. He thinks that it is a good buy at 51, but feels that the stock might pull back in the near term. He is concerned with market or stock volatility, but not enough to stop him from making the purchase now. Instead of buying all 1,000 shares at this time, 500 shares could be purchased and a combination sold. If the stock declines, the investor may be obligated to purchase additional stock; and, if the stock rises, the investor may be obligated to sell the stock. However, if the stock remains between the call strike and put strike, both premiums will be retained with no obligation at expiration. Commissions have not been taken into consideration in these examples; however, they can have a significant effect on your returns. The transaction looks like this: Buy 500 shares ZYX at 51 $25,500 Sell 5 three-month 55 calls at 2.25 1,125 Sell 5 three-month 45 puts at 2 1,000 Net Cost = $23,375 ($46.75 avg. price per share)

Stock Called Away at Strike Price 55-1/4 Less Breakeven Price -46.75 Proceeds from Sale +8.25 The proceeds from the sale of $8.25 is a 17.6% return on investment in three months. Keep in mind that no matter how high ZYX rises above 55, the call seller has the obligation to sell ZYX at 55. However, he has taken in both the put and the call premium to offset some of the upside potential that might be missed. II. ZYX is between the strikes (45 and 55) at expiration. The seller will not be assigned and the stock is retained along with the two premiums and any dividend paid. Purchased Stock Less Call Premium Less Put Premium Breakeven Price 51 - 2.25 -2 46.75

The stock is still held, but the breakeven is now reduced by the premiums received from selling the combination. This position results in a loss if ZYX is below 46.75. The investor may now choose to sell another combination against the existing stock position, if his opinion on the underlying stock has not changed. By selling both an out-of-the-money put and a call a second time, the breakeven on the stock would once again be reduced by the premiums received. III. ZYX is below 45 at expiration. Having sold the put the investor has the obligation to purchase ZYX at 45, no matter how low the stock has fallen below the strike. However, he has now doubled his position on a stock that he was willing to own and will have received premiums from having sold the options. Owns 500 shares Less Call Premium Less Put Premium Breakeven/Net Cost Purchased 500 shares (put assignment) 51 -2.25 -2-1/4 46.75 45

the rest on a pullback and took in two option premiums in the process, a new breakeven of 46 has been created. The position has a net cost of $46,000. This example uses short-term options. If an investor would like to use this strategy but over a longer time horizon, LEAPS are available. LEAPS, Longterm Equity AnticiPation SecuritiesTM, are simply long-term stock and index options. Assignment prior to expiration The possibility always exists of the stocks price fluctuating above the call strike price and below the put strike price prior to expiration. If this should happen, the original stock position would be called away and the investor would have to buy shares of the stock due to the assignment of the short put. To avoid this from happening, should the investor be assigned on one side, he then might want to close out the other side. Otherwise, the investor would be exposed to any price movement beyond the remaining strike price.

Summary
The Covered Combination allows an investor to be paid to have the obligation to add to his position in a stock he already owns and likes, while lowering his breakeven on the purchase. Also, it gives the covered call writer an opportunity to enhance his rate of return because he has received a premium for having sold a put as well as a call. The covered combination writer adds to his position on a pullback, lowers his breakeven in a static market, and has a better rate of return than a covered call writer in an up-market.

New Total Stock Position: 1000 Shares @ 46 The investor is now long 500 shares at 46.75 and 500 shares at 45.25. The average price per share/ breakeven after the put is assigned is 46. If this investor had originally bought 1000 shares of ZYX at 51, it would have cost him $51,000. Since this investor bought half of the position at 51 and

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Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by contacting your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation at www.theocc.com. In order to simplify the computations, commissions, dividends, fees, margin interest and taxes have not been included in the examples used in this document. These costs will impact the outcome of stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. The strategy discussed above is strictly for illustrative and educational purposes only and is not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. LEAPS is a registered trademark and Long-term Equity AnticiPation SecuritiesSM is a service mark of Chicago Board Options Exchange, Incorporated (CBOE). Copyright 2012 CBOE. All rights reserved.