Covered Combination Explained

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Covered Combination

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. Support for this pricing relationship is based upon the argument that arbitrage opportunities would materialize if there is a divergence between the value of calls and puts. Arbitrageurs would come in to make profitable, riskless trades until the put-call parity is restored.

To begin understanding how the put-call parity is established, let’s first take a look at two portfolios, A and B. Portfolio A consists of a european call option and cash equal to the number of shares covered by the call option multiplied by the call’s striking price. Portfolio B consist of a european put option and the underlying asset. Note that equity options are used in this example.

Portfolio A = Call + Cash, where Cash = Call Strike Price

Portfolio B = Put + Underlying Asset

It can be observed from the diagrams above that the expiration values of the two portfolios are the same.

Call + Cash = Put + Underlying Asset

Eg. JUL 25 Call + $2500 = JUL 25 Put + 100 XYZ Stock

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If the two portfolios have the same expiration value, then they must have the same present value. Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued portfolio to make a riskfree profit on expiration day. Hence, taking into account the need to calculate the present value of the cash component using a suitable risk-free interest rate, we have the following price equality:

Put-Call Parity and American Options

Since American style options allow early exercise, put-call parity will not hold for American options unless they are held to expiration. Early exercise will result in a departure in the present values of the two portfolios.

Validating Option Pricing Models

The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

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Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

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Covered Call

What Is a Covered Call?

A covered call refers to transaction in the financial market in which the investor selling call options owns the equivalent amount of the underlying security. To execute this an investor holding a long position in an asset then writes (sells) call options on that same asset to generate an income stream. The investor’s long position in the asset is the “cover” because it means the seller can deliver the shares if the buyer of the call option chooses to exercise. If the investor simultaneously buys stock and writes call options against that stock position, it is known as a “buy-write” transaction.

Key Takeaways

  • A covered call is a popular options strategy used to generate income in the form of options premiums.
  • To execute a covered call, an investor holding a long position in an asset then writes (sells) call options on that same asset.
  • It is often employed by those who intends to hold the underlying stock for a long time but does not expect an appreciable price increase in the near term.
  • This strategy is ideal for an investor who believes the underlying price will not move much over the near-term.

Covered Call

Understanding Covered Calls

Covered calls are a neutral strategy, meaning the investor only expects a minor increase or decrease in the underlying stock price for the life of the written call option. This strategy is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously has a short position via the option to generate income from the option premium.

Simply put, if an investor intends to hold the underlying stock for a long time but does not expect an appreciable price increase in the near term then they can generate income (premiums) for their account while they wait out the lull.

A covered call serves as a short-term hedge on a long stock position and allows investors to earn income via the premium received for writing the option. However, the investor forfeits stock gains if the price moves above the option’s strike price. They are also obligated to provide 100 shares at the strike price (for each contract written) if the buyer chooses to exercise the option.

A covered call strategy is not useful for a very bullish nor a very bearish investor. If an investor is very bullish, they are typically better off not writing the option and just holding the stock. The option caps the profit on the stock, which could reduce the overall profit of the trade if the stock price spikes. Similarly, if an investor is very bearish, they may be better off simply selling the stock, since the premium received for writing a call option will do little to offset the loss on the stock if the stock plummets.

Maximum Profit and Loss

The maximum profit of a covered call is equivalent to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.

The maximum loss is equivalent to the purchase price of the underlying stock less the premium received.

Covered Call Example

An investor owns shares of hypothetical company TSJ. They like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a couple dollars of its current price of $25.

If they sell a call option on TSJ with a strike price of $27, they earn the premium from the option sale but, for the duration of the option, cap their upside on the stock to $27. Assume the premium they receive for writing a three-month call option is $0.75 ($75 per contract or 100 shares).

Combination Tricast Bet Explained

A combination tricast is an alternative to a straight tricast and that is because it uses the selections to create a variety of bets instead of just one. The combinations of different bets still need to predict the top three finishers in an event.

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Table of Contents

What is a Combination Tricast bet?

A combination tricast bet takes three selections, just as it would be in a tricast, and forms them into all combinations of possible outcomes. The final result needed is the prediction of the top three in a horse race in any order. This type of forecast bet is commonly used in horse racing and greyhound racing only.

In contrast, a tricast is one bet calling the exact order of the three. So with three selections, a total of six different bets are made in a combination tricast. Each of those bets require its own unit of stake.

How does a Combination Tricast bet work?

The combination tricast ensures that all potential outcomes of a 1, 2, 3 finish in a race from your predictions are covered. For example let’s say that Phar Lap, American Pharoah and Habitat were the selections.

Here are the potential combinations of top three finishes that they could produce and this is how a combination tricast works, by creating a bet for each possible outcome:

1st 2nd 3rd
Bet 1 Phar Lap American Pharoah Habitat
Bet 2 Phar Lap Habitat American Pharoah
Bet 3 American Pharoah Phar Lap Habitat
Bet 4 American Pharoah Habitat Phar Lap
Bet 5 Habitat Phar Lap American Pharoah
Bet 6 Habitat American Pharoah Phar Lap

Winning example of a Combination Forecast in Horse Racing

So taking the same horses from above, you would only need any of those scenarios to play out for your combination tricast bet to win. As with most forecast bets though, you really are not going to know your exact winnings until the race is in the book.

That is because bookmakers will use the Starting Price, then calculate at the close of the race a winning dividend for a combination tricast. This will be a monetary value, such as £12.23 or £143.65 for example.

Whatever that dividend value is, will then be multiplied by the unit of stake that was used for the winning bet.

£1 Combination Tricast
£1 unit Stake
6 bets = £6 unit stake

For example, if Bet 2 was the outcome of your bet then you would multiply £1 x 12.23 (or whatever the dividend is) to get your payout. Because none of the other five bets within the Combination Tricast won, those stakes won’t be returned.

Losing example of a Combination Tricast in Horse Racing

The appeal of this bet type is that all possible outcomes from your selections are covered. So if your three selections come in in any order, you win. But that doesn’t, of course, account for all of the other runners in a race.

It takes only one of the three selections in the combination tricast to not place within the top three and the whole thing fails. For this example, Phar Lap failed to secure a top-three finish in the race and you can see all bets are wiped out because of his inclusion in all six of them.

1st 2nd 3rd
Bet 1 Phar Lap American Pharoah Habitat
Bet 2 Phar Lap Habitat American Pharoah
Bet 3 American Pharoah Phar Lap Habitat
Bet 4 American Pharoah Habitat Phar Lap
Bet 5 Habitat Phar Lap American Pharoah
Bet 6 Habitat American Pharoah Phar Lap

How many bets in a Combination Tricast?

There are six bets in total. Each one of those bets will need its own unit of stake against it. That is how many different combinations of trebles that you can create from three selections.

How to work out a Combination Tricast odds?

Combination tricast odds are not something that can be accurately portrayed before a race. That’s down to Starting Prices being used and not fixed odds on the individual horses when placing a bet. Combination tricast calculators can be complicated to use as well, so the simplest way is to study recent results and what dividends were paid out. Look at the odds of the top three finishers, number of runners and see what the dividend was (as a ballpark idea).

Combination Tricast Strategy

At the end of the day, you are looking for three selections to come good under one umbrella of a bet. It’s not a particularly easy thing to do, even in a race with a moderate number of runners, such as eight. So picking stronger options as opposed to those with only an outside chance, is common practice.

However, making a forecast is certainly a lot easier to do with a Combination Tricast than with a straight tricast where you are relying on an exact 1, 2, 3 prediction from one bet. The combination tricast offers all those extra outcomes, although it will require extra stake compared to a straight tricast. It is still common practice to select stronger options as opposed to outside chances.

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