Covered Combination

Chinese food topped with a napkin…or an options strategy designed to generate income for traders. This scenario calls for the acceptance of the second.

Covered combinations are a way to get cash while hoping that the stock goes higher to bolster returns. The process involves the sale of an out of the money call option and an out of the money put option. The seller generates cash from the premiums on both options. The primary risk is that they might need to buy the stock should the price fall below the strike price.

Let’s look at how it works. A stock trades at $20 per share. The trader sells a put for $15 and a call at $25 with an expiration date in six months. The trader will collect premiums on both sides of these deals. So long as the stock remains in a range between $15 and $25, the investor will collect premiums on both deals and the options will expire...worthless. If the stock rises above $25, the investor will pocket the premiums from the puts and sell their stock at a gain (although not as high as it could have been). If the stock falls below $15, the investor will have to buy more of the stock at a value that is higher than what it might trade at around expiration.