Credit/Credit Spread Strategy:
Covered Combo

ANALOGY/METAPHOR: Being Both Landlord and Discount Stock Acquirer - Leasing your Own Stock while Negotiating to Purchase More

ACTION: Own or purchase 100 shares of stock. Write 1 out of the money (OTM) covered call and 1 OTM naked put. Both options expire worthless (and you keep all the premium) if the stock closes between strike prices. Otherwise you'll either be selling the 100 shares that you have at the call option strike price or purchasing another 100 shares at the put option strike price.

DESCRIPTION: The covered combo is an intriguing strategy. There are different schools of thought as to whether it's ingenious and clever, or whether it's self-defeating and dumb.

But the most important thing to realize is that despite its characterization and description, the covered combo option income strategy is essentially two separate and distinct strategies lumped together: a covered call and a naked put. This is not a single transaction or strategy. Writing the Naked Put will be collateralized by cash (or possibly by existing stock positions). Yes, you're getting two sources of premium. But you're not getting them at any better rate or advantage than if you'd set up either one of those positions individually.

EXAMPLE: The XYZ Zipper Company is currently trading for $32.50/share. Let's assume you were fortunate enough to purchase 100 shares of the stock two or three months earlier at $30/share. You think it's a solidly run company, but it's not about to triple in price anytime soon. In short, although you like the stock, in the interest of maximizing profits, you would be willing to sell your position in the near term. And, what the hell? You wouldn't mind picking up more shares if the price pulled back.

You decide to employ the covered combo option trading strategy. You sell a covered call three months out at the $35 strike price for a $1.50/contract premium. Additionally, you write a naked put, also three months out, at the $30 strike price for another $1.50/contract premium. In exchange for pocketing $300 in premium, you obligate yourself to potentially having to either sell your existing position for $35/share or purchase another 100 shares at $30/share.

The possible outcomes:

• The stock closes $30-35/share. You've done very well for yourself. The buy and hold investor would have virtually nothing to show for those same three months (excluding dividends). But your $300 in premium in effect serves as a special 10% dividend (calculated off your original $30/share purchase) or a 10% reduction of your original cost basis (from $30/share to $27/share).

  [An important sidenote on calculating your returns: in the above example, the 10% returns generated by the options premium received should actually be reduced to 5%. For most, if not all, brokerages, the naked put portion of your covered combo position isn't secured by your 100 shares of XYZ, but rather by an additional $3000 in cash. So the real initial capital investment is $6000, not $3000.]

• The stock does well over the next three months and cruises up to $40/share. You really can't complain, but you would've done better if you hadn't tried to get fancy and set up a covered combo in the first place ($1000 gains vs $800 gains). The covered call portion of the trade forced you to sell your 100 shares for $35/share. You miss out on a full $5/share in capital appreciation, but that's somewhat offset by the $3/share you collected in option premium.

• The stock runs into trouble and finishes at $25/share. This is probably not the scenario you envisioned when you first set up the trade. You now own 200 shares of The XYZ Company. When the naked put was assigned to you, you were obligated to purchase your second position in the stock at $30/share (ironically, that's what you paid for your first 100 shares as well). But because of all the collected premium, your adjusted cost basis lowers from $30/share to $28.50/share ($6000 less $300 = $5700 divided by 200 shares = $28.50/share). That's better at least than if you'd simply bought the entire 200 shares at the time of your original investment and then done nothing at all involving options.

VARIATIONS: Depending on your objectives, you can choose strike prices either farther out of the money or closer to being at the money.

Instead of a $30-$35 range in the example above, you could write the covered call at the $37.50 strike price and sell the naked put at the $27.50 strike price. You'll receive less income, of course, but you increase the odds that both options will expire worthless. You can then repeat this trade as an effort to generate smaller but more consistent amounts of regular income.

Or you can go the opposite route and write both covered call and naked put right ATM. In the above example, that would be $32.50/share. Should you set up the covered combo this way, there's no middle ground. When the dust settles, you'll own either 0 shares or you'll own 200 shares. But you will also have collected a whole lot of premium which should offer some reasonable protection against big moves in the stock.

OTHER: There are both pros and cons for the covered combo option trading strategy.

THE ADVANTAGES

1. Best suited for the investor/trader who has plenty of cash in a brokerage account already receiving a decent money market rate.
2. Enables you to write farther OTM options and receive a comparable amount of premium than by selling either covered calls or naked puts alone.
3. Theoretically forces you to buy low and sell high, although this is a relative measure and is only effective if the underlying stock is range bound.

THE DISADVANTAGES

1. Potentially ties up a lot of capital if your brokerage requires the puts your write (naked puts) to be cash secured (i.e. having enough cash to cover in full what it would cost if you were assigned on all your short option positions).
2. Instead of decreasing your chance of assignment by allowing the trader/investor to write farther our of the money options, you've arguably increased the chances because now you can be assigned if the stock moves big in either direction rather than in just one direction.
3. You lose in either direction if the stock is in a long term uptrend or downtrend. If the stock is in an uptrend, you lose by being assigned and missing out on capital appreciation. More seriously, if the stock is in a downtrend, you lose by having to put more money into a losing position. The situation compounds if you continue writing new covered combo positions as the stock continues to sink lower and lower. You would also want to keep track of your overall cost basis on all the positions you owned to ensure that you weren't setting up trades that put you at risk of being assigned for a loss.
   
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