By: Wayne Duggan
The options market may seem extremely complicated and dangerous to a beginner. While there are certainly plenty of ways to ramp up leverage, volatility, and risk trading options, there’s nothing inherently dangerous about options trading as long as traders fully understand their strategy and the range of potential outcomes.
Here’s a close look at a common options trading strategy known as “covered combinations.”
A covered combination strategy is a potential way for traders to generate some additional income from a core stock holding. The idea is simple: By selling an equal number of out-of-the-money call options and put options, a trader is essentially betting that the underlying stock will not trade outside of the price range between the strike price of the calls and the strike price of the puts by the expiration date.
The best-case scenario for the options seller is that the underlying stock trades up to or above the strike price of the call option by the expiration date. If that happens, the options seller’s profits include gains on the underlying stock up to the strike price of the call contracts plus the net premiums received from the sale of the calls and the puts.
Unfortunately, any additional upside for the underlying stock above the strike price of the call contracts is lost because the call buyer has the right to buy those underlying shares at the strike price. Essentially, the call seller has sold the rights to any upside above the strike price of the call contracts.
The second best-case scenario is that the underlying stock trades between the strike prices of the call and put contracts on the expiration date. In that scenario, the options seller gets to keep his underlying shares of stock and also the premiums from both the call and put contracts. Both sets of contracts expire as worthless.
To calculate the break-even point for a covered combination trade, take the purchase price of the underlying stock, add the strike price of the put contract and subtract the net premium received from the sale of the options contracts. Finally, divide the total by 2.
Assume a trader buys 100 shares of a $25 stock and sells out-of-the-money calls at a strike price of $28 and out-of-the-money puts at a strike price of $22. In this scenario, the cost of the underlying shares of stock would be $2,500, and the trader might collect another $100 in options premiums from the sale.
If the stock rallied to $30 by the expiration date of the contracts, the puts contract would expire as worthless and the shares of stock would get called away for $2,800. The total profit would be $300 plus the $100 in premiums for a net gain of $400.
Using the calculation method above, the break-even point of the trade on the downside would be $23. The trader would only incur net losses if the stock price dropped below $23.
However, it’s extremely important to note that the put contract seller has an obligation to buy 100 shares of the underlying stock at the strike price if the contract is exercised. Therefore, if the stock crashes well below the strike price of the put contract, the seller will essentially be incurring losses on both the 100 underlying shares they already own and the additional 100 shares they will be obligated to buy.
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