CHAPTER
10

Combination Strategies

In This Chapter

• How puts, calls, and the financial market work together
• Using puts and calls together to manage risk and return
• Risks of using combination strategies
• Strategies you can use when trades don’t work out

Puts and calls work together. In essence, owning the underlying asset is the same as being long a call and short a put. You make money when the underlying asset goes up in price and you lose it if it goes down.

Furthermore, a long call has a similar payoff to a short put, and a short call has a similar payoff to a long put. There might be times when prices on the different options are out of alignment, or where you’re looking at different movements in prices over time. That’s just the first of many reasons to think of puts and calls in combination.

That’s the starting point for trading strategies that rely on a combination of puts and calls. This chapter will cover the terms and strategies involving option combinations.

Keep in mind that many of these strategies are used by professional traders. Low-risk, low-profit strategies might bring in pennies for an individual. A proprietary trader with access to leverage and low transactions costs might find that a strategy that’s not a good use of your time is a great trade for him. Other combination strategies might be used by trading firms to hedge their own risks, or to offset other positions. You might hear about these combinations and want to learn what they are. However, they might not be good for your trading.

Combination Spreads

A basic spread involves owning a combination of puts and calls, or owning them in different forms, in order to profit from price changes.

Back Spread

A back spread occurs whenever a trader has more long options than short options on a given underlying asset. This is something that a trading firm might get into but not one that an individual will face. A trading firm would want to determine the risk of loss and then manage it appropriately.

For example, suppose that a brokerage firm risk manager looks at the open interest and finds that there are 100 long calls and 80 short calls on the same underlying asset. If the price of the underlying asset moves up, then she can exercise the long calls. The short calls will be exercised, too, but the profit will be greater than the cost of fulfilling the option assignment.

If the underlying asset falls in value, then the short options expire worthless and the firm can keep the premium. However, it will have spent more on the long calls (probably), so it will have a net debit position.

The opposite happens if the back spread involves puts. If the underlying asset falls below the strike price, then the long puts are in-the-money but the short puts will be assigned. If the underlying asset closes above the strike, then the short puts will expire worthless. This means the firm can keep the premium—but it will have lost premium on the long puts.

Diagonal Spread

To set up a diagonal spread, a trader buys one option and sells another of the same type with different strike prices and different expiration dates. This combination profits from a change in the direction of the underlying over time.

For example, you sell a 37.50 March call for $0.55 and then buy a 42.50 May call for $0.29. You now have a net credit position of $0.55 – $0.29 = $0.26. If the March option is assigned, then you lose the cost of the stock, but that would increase the value of the May call. (By how much? Who knows?) If the March call expires, you then sell a May 42.50 call to close out the position, increasing your net premium. This has somewhat less risk than a naked-short-call position, but it requires paying attention to the price of the underlying asset.

This strategy has limited risk, but it also has limited profit potential. It may be one of these strategies that exists because it makes for an interesting payoff graph, not because it’s particularly useful.

Box Spread

A box spread is so called because the payoff diagram forms a box. It involves a long call and short put at one strike price, along with a short call and a long put at another strike price. This matches the payoff of a long stock position at one price with that of a short stock position at another price. Your payoff, therefore, is within the box.

Here’s what it would look like. Start with the first part: a long call and short put. You buy a 55 October call for $2.85 and sell a 55 October put for $6.95, for a net credit of $6.95 – $2.85 = $4.10. Then, you sell a 57.50 October call for $2.05 and buy a 57.50 October put for $8.60, for a net credit of $2.05 – $8.60 = –$6.55. Your total cost of this position is $4.10 – $6.55 = –$2.45.

Now, what do you receive in exchange for that $2.55 cost? If the price of the underlying asset is below $55 at expiration, then the long call expires worthless. The short put will be exercised, so you’ll have to purchase the asset for $55. The short call will also expire worthless, and the long put will be in-the-money, so you can sell the stock that you bought at $55 for $57.50, for a $2.50 profit. Subtract the $2.45 cost, and your profit is $0.10.

That’s all well and good, but what happens if the underlying exceeds $57.50 at expiration? Your long call will be in-the-money and your short put will expire worthless. Your short call might be assigned, so you’ll end up with the difference between the stock’s purchase price and its sale price, or $57.50 – $55.00 = $2.50. Subtract the $2.45 cost, and you have a profit of $0.10.

This only works if you can establish the box at a lower cost than the maximum profit. You might not find many situations that fit.

Straddles and Strangles

Straddles and strangles seem dangerous, don’t they? In reality, they are more like the butterflies and condors of Chapters 8 and 9. The difference? They are established with puts and calls, rather than only puts or only calls.

Straddles

A straddle is similar to a butterfly. It is a way to play volatility. You can think of it as two options that “straddle” a common strike price, looking for prices that deviate from that central point.

Long Straddle

A long straddle involves the purchase of a call and a put with the same strike price. If the options expire at the strike price, then the loss is the maximum of the combined premium on the two options.

This trade moves in-the-money if the asset goes up or down in price, but the amount made over the premium paid might be pennies unless there is a significant movement in the underlying price. If the asset goes up or down, the profit is equal to the underlying price minus the premiums paid.

Here’s an example: 100 May calls cost $2.85, and 100 May puts cost $5.70 on a particular asset. You buy both for $8.55. If the underlying is at $110 on expiration, then the call can be exercised and the put expires worthless, for a profit of $10.00 – $8.55 = $1.45. If the underlying is at $90 at expiration, the call is worthless and the put can be exercised for a profit of $10.00 – $8.55 = $1.45.

The payoff diagram looks like this:

The strike price and the combined premium (maximum loss).

A long straddle is used when a trader perceives volatility in the market but is uncertain which direction it will take.

Short Straddle

A short straddle involves the sale of a call and a put with the same strike price. If the options expire at the strike price, then both options are in-the-money, and the profit is at a maximum: the combined premium on the two options.

This position loses money if the asset goes up or down in price. If the asset price is anything other than the strike price, the loss is equal to the strike price minus the premiums paid. The problem here is that you will need to maintain margin in your account to cover the short positions. Doing so can get really expensive really fast. As a result, short straddles are the province of deep-pocketed professional traders.

The payoff looks like this:

The strike price and the combined premium (maximum profit).

Short straddles are used by traders who expect very little volatility in the market. Because a market with no volatility is not common, this is a risky trade.

Economics of Straddles

	Long Straddle	Short Straddle
To establish	Net premium	Net premium
In-the-money	Difference between the price of the underlying asset, strike, and net premium	Net premium
Out-of-the-money	Lose net premium	Lose difference between the price of the underlying asset, strike, and net premium
Upside potential	Difference between the price of the underlying asset, strike, and net premium	Net premium
Downside potential	Net premium	Lose difference between the price of the underlying asset, strike, and net premium
Market view	Volatile	Flat

Strangles

Options strategies have so many fanciful names! A strangle is a trade using options with the different strike price on the same expiration.

Strangles are similar to straddles, but they allow more wiggle room on the amount of volatility tolerated. The payoff is identical to that of a condor (see Chapters 7 and 8), but they are set up using both puts and calls rather than one or the other.

Long Strangle

A long strangle is established by purchasing both a call and a put with different strike prices, usually out-of-the-money. For example, you buy a 45 July call for $1.52 and a 33 July put for $2.75 on an underlying asset trading at $39. The net credit position of the combined premium is the $4.27 that you paid to establish the position.

The maximum loss is that $4.27 combined premium, should both positions expire out-of-the-money. The maximum profit is the difference between the underlying price and the premiums paid.

The following graph shows the range of maximum profit for the long strangle.

The range of maximum profit for the long strangle and the combined premium (maximum loss).

This allows a trader to take advantage of volatility at a lower cost than with a straddle. The strangle can be arranged with either out-of-the-money or in-the-money options. Using in-the-money options minimizes the break-even point, but also has a larger potential loss if the position expires worthless.

The range of loss for the short strangle and the combined premium (maximum profit).

This position allows a trader to generate income in a sideways market. As long as the underlying asset stays in the range between the strike prices, the trader will see a profit. A short strangle has much less risk than a short straddle, but it still has risk, and it has very large margin requirements.

Economics of Strangles

	Long Strangle	Short Strangle
To establish	Net premiums	Net premiums
In-the-money	Difference between the price of the underlying asset, strike, and net premium	Net premium
Out-of-the-money	Lose net premium	Lose difference between the price of the underlying asset, strike, and net premium
Upside potential	Difference between the price of the underlying asset, strike, and net premium	Net premium
Downside potential	Net premium	Lose difference between the price of the underlying asset, strike, and net premium
Market view	Volatile	Flat

Iron Butterflies and Iron Condors

An iron butterfly or an iron condor is similar to a regular butterfly or condor except that it involves selling the midstrike straddle and buying the surrounding strangle. It’s simply another way to arrange the strike prices, using both puts and calls. The names are just irresistible, aren’t they?

Collars and Fences

Collars and fences are synonyms for the same strategy: having a long call and a short put, or a short call and long put, at different strike prices above and below the price of an underlying asset.

For example, suppose you wanted to hedge against the price of a stock market index falling. To do this, you would buy puts on the index with an exercise price below current levels. To offset the cost of the puts, you would write calls on a price above current levels. If the market falls, your long put position protects you. If the market goes up, though, your appreciation potential is limited.

You do not need to have a position in the underlying asset to set up a collar or a fence, although the combination is often set up in order to hedge an underlying position.

A conversion is related to the collar. It is an arbitrage strategy that involves purchasing stock, a long put, and a short call. The put and call should have the same strike price and expiration. The result is a nearly riskless profit on the downside. The main risk is having the short call exercised, which would mean you lose the underlying asset.

Rolls, Jelly and Plain

A roll is a trade that involves closing out one open option position and opening a new position at a different strike price, different expiration, or both. It the new strike price is higher, this is a roll up; if lower, it’s a roll down; and if it’s for a later time period, it’s a roll out.

A jelly roll is a special form of roll that involves a long call and a short put with the same strike price and same expiration coupled with a short call and long put with the same strike price with a later expiration. This is a form or a collar or fence that extends out over time.

Strips and Straps

Sometimes, a trader wants to reduce risk but not eliminate it entirely. Strips and straps fit the bill in these situations, and are often used by professionals in managing the risk of a large options portfolio.

A strap involves two calls and one put, usually long. (You can short two calls and a put as a bear strap, but that’s a risky proposition.) All options have the same strike price and expiration, and they work on the same underlying asset.

A strip is similar, but it involves two puts and one call. Like a strap, it can be long or short. It can be bullish, if long, or bearish, if short.

Repair Strategies

Your trading positions are not always going to go according to plan. There are options strategies you can use to increase the probability of profit or reduce the size of losses.

Closing out the position is one alternative—and that should be done if research shows your original idea no longer holds—but repair strategies increase the tools in your toolbox. The idea is to look for a similar payoff, but buy some time and space by changing expirations or strike prices. Furthermore, the ability to generate income from writing options can help increase return for very little additional risk.

Option Repair

An option repair starts with assessing the problem. Why is the trade not working out?

If the problem is that you are dead wrong in your analysis, but you are wishing and hoping that is not the case, you should get out now. If you check your research and still feel confident about the basic approach you are taking, a repair gives you some alternatives that might increase your likelihood of being in-the-money, albeit at the cost of some profit potential.

If the problem is that your option position is starting to look unlikely to pay off for you, the first step is to look for ways to trade in those options that are looking unlikely to work out for some that are more promising. Buying a little more room on the exercise or a little more time to expiration is unlikely to cost a lot, especially after the old position is closed.

A second strategy is to replace a single option position with a spread. A bull spread can replace a long call, and a bear spread can replace a put. This gives you a wider range of possibilities for profit.

The Least You Need to Know

• Puts and calls are usually used in combination.
• Different strategies can achieve the same risk management or profit goals.
• Combination strategies are especially popular as hedges.
• Repair strategies help correct problems with other trades using options.