A combination is an option strategy that deals with one or more option types. Typically traders use combinations for the fact that it allows for personalized strategies to minimize risk in volatile markets.
In a combination trade, the trader will in turn take on a call and put options on the same stock.
How Does a Combination Work?
Combinations refer to options strategies that allow traders to invest in options that have balanced risk and reward trade offs. These strategies are made up of more than one option contract.
Combinations involve vertical spreads, diagonal spreads, and calendar spreads. Traders use these options strategies to purchase and or sell calls and puts under the same underlying security.
Example of a Combination
Options combinations can either limit the amount of risk or use the volatility and time decay to increase profit. For our example, let’s use the bull call spread combination strategy.
In this case, we will need to sell a call option while purchasing an option at a lower strike price. Let’s say we think XYZ company will be trading at $50 by May.
We in turn purchase a long call with a lower strike price, as well as a short call with a higher strike price to offset the risk. This way, risk for loss decreases if the stock price drops below the strike price of the long call.
If XYZ stock rises to $57 per share by May then we will take a profit from this investments. In this situation we acquire more risk as time moves on.
How Are Combinations Useful?
Because combinations comprise such a large variety of strategies, there is a choice, best for each investor. Combinations are useful for the main purpose of protecting assets from extreme risk.
Types of Combinations
There are a variety of types of combinations traders can use. Let’s go over each combination type and what they offer depending on the traders goals and risk tolerance.
Vertical spreads are an options strategy where the trader holds a long and short position with different strike prices but same maturity dates and of the same underlying asset. Traders use vertical spreads to help hedge against directional risk and maximize profits.
Vertical spreads can either be bullish or bearish. Bullish spreads maximize the traders profit when the stocks underlying asset’s price rises. While a bearish spread becomes profitable when the underlying security drops in price.
Calendar Spreads/Horizontal Spreads
A calendar spread is used by traders for the fact that it’s extremely low risk, as it’s known as a neutral strategy. This strategy consists of traders buying the same security with the same strike price but at different maturity dates.
Horizontal spreads benefit off of volatility in the underlying stock due to short-term environmental factors. Calendar spreads are also futures strategies.
A diagonal spread is a strategy optimized by traders to hedge assets from market movements. Traders using this method will enter a trade with a long and short position that is equipped with different strike prices and expiration dates.
This strategy shares ideology of both horizontal/calendar spreads and vertical spreads.
Types of Call And Put Buying Combinations
There are numerous call and put combinations traders can optimize to make profitable trades.
A straddle strategy is an options strategy that traders employ by entering into a trade by purchasing a call and put option with the same underlying asset. The trade has to have the same strike price and maturity date.
Investors often use the straddle strategy when they believe the stock will drastically move upwards or downwards.
A strangle combination is used when the trader believes the stock is to have an upward trend, but wants to continue to hedge funds against risk. While a straddle and a strangle are similar, a strangle incorporates two varying strike prices when a straddle has a common strike price.
Aside from the varying strike prices, the call and put options must be from the same underlying asset and have the same date to maturity.
A strip combination of options contracts based on a particular underlying asset that often shares a similarity. Strip combinations are used in bearish markets, which means they increase in profit from downward movements.
Traders may find this strategy beneficial when looking to invest into options with a known/set amount of risk. This is due to the fact that the amount that can be lost is the amount paid for the options.
A strap combination is a strategy employed by traders looking to gain profits from high risk stocks moving up or down in price. Stap combinations offer traders unlimited profit potentials on upward movements but limited potential in downward trends.
It’s typically advised for traders to avoid this strategy in the long term due to the fact that there is high premium cost.
Benefits of Combinations
- Uncertainty is okay: While using combinations, there is a lot of wiggle room when determining what underlying asset has a greater risk/reward trade off.
- Fit specific needs: Depending on the amount of risk the trader is comfortable with, the trainer can hatch their funds with their own needs based on market trends.
- Multiple ways to execute: Whether the trader is extremely knowledgeable of combination strategies or not, there are a wide variety of approaches that can suit an individual’s level of understanding.
Disadvantages of Combinations
- Added on cost: While combinations allow for extreme flexibility and personalization, there is an added cost. Combinations can be a pricey strategy to employ, the more you use this method, the more overall expenses will be a wicked of brokerage fees.
What Is Synthetic Underlying?
A synthetic underlying position is acquired without having to purchase or sell an underlying asset. To use this strategy traders will instead sell calls and puts at the same time.
Synthetic options consists of long and short positions. For example, a synthetic put is a short position in a stock along with a long position that holds a call option at the money.
While a synthetic call is a long position in a stock along with a long put that’s at the money. Synthetic positions are used by traders simply for the reason that they diminish the risk.
What Are Synthetic Underlying Positions?
A synthetic underlying position doesn’t require you to have already purchased or sold the underlying security. Instead, you would only need to acquire a call and put option of the underlying security.
Need Help Understanding Combinations?
There are many ways to employ combinations in trading. Before making the decision on what strategy may work best for your portfolio, check out what a financial advisor can do for you.