!7# Covered Combo Option Trading - An Introduction

!±8± Covered Combo Option Trading - An Introduction

The Covered Combo is a unique and lesser known option trading strategy. Actually, it's comprised of two separate trades that are much more common - the covered call and the naked put.

A covered call is written against stock that you own. As with all options, one contract equals 100 shares. In exchange for a single, one-time cash payment (called premium) you sell someone else the right to buy your stock at a certain price (strike price) by a certain date (expiration date).

If the stock is trading above the strike price when the option expires, the call will be exercised and you will be obligated to sell your shares at the agreed upon price. If the stock is trading below that strike price at expiration, the call will be worthless, you will retain ownership of the shares, and you are then free, if you so desire, to write a new covered call with a future expiration date.

Conversely, when you sell, or write, a naked put (it's called naked because it's not written against or hedged by any other position), you are giving someone else the right, but not the obligation, to sell you 100 shares of a certain stock at the strike price on or before expiration. That means you're offering to buy someone else's stock within a predetermined time range at a specified price (presumably lower than where the stock currently trades). Essentially, you're functioning as an insurance company.

As with the covered call, you collect a cash premium payment. As long as the stock closes above the strike price, the put expires worthless and you are under no obligation to purchase any shares. You are then free to write another put and repeat the process. But if the stock does close below the strike price, you will be obligated to purchase the shares at the specified price, although your purchase price is offset by the amount of premium you received.

The covered combo combines these two trades. By simultaneously writing a covered call AND a naked put, you are increasing the amount of premium you receive. The downside, however, is the general unpredictability of the trade since there are three potential outcomes, all of them very different.

Possible Outcomes:
The stock makes a big move to the upside and your covered call is exercised. You now have zero shares of stock and are completely in cash. The stock makes a big move to the downside and your naked put is exercised. You now have 200 shares of the underlying stock. The stock trades neither above nor below the two strike prices. You retain the 100 shares of stock and have successfully produced some rather solid and uneventful cash flow for this expiration cycle.

In short, there's no telling what's going to happen with this trade. It's an unusual trade, appealing only if you're comfortable with the possibility of very different outcomes - you may very well end up having to purchase more stock or selling what you already own or nothing may happen and you simply net some decent income. There is some flexibility to the trade, however, in what strike prices you choose and--since the call and the put don't have to be written at the same time - the timing of when you add each leg.