Combination
What Is a Combination?
In options trading, a combination is a blanket term for any options trade that is built with more than one option type, strike price, or expiration date on a similar underlying asset. Traders and investors use combinations for a wide assortment of trading strategies since they can be built to give specific risk-reward settlements that suit the individual's risk tolerance and inclinations and expectations for the current market environment.
How a Combination Works
Combinations are made out of more than one option contract. Simple combinations incorporate option spread trades, for example, vertical spreads, calendar (or horizontal) spreads, and diagonal spreads. More elaborate combinations incorporate trades like Condor or Butterfly spreads which are really combinations of two vertical spreads. A few spread trades don't have recognized names and may just be alluded to generically as a combination spread or combination trade.
Recognized combinations, for example, vertical spreads are frequently accessible to trade as a pre-defined gathering. Yet, modified combinations must be put together by the individual trader and may require different orders to put them in place.
Contingent upon the individual's requirements, option combinations can make risk and reward profiles which either limit risk or exploit specific options attributes, for example, volatility and time decay. Options combination strategies exploit the numerous decisions accessible in the options series for a given underlying asset.
Combinations contain a great many broad methodologies, starting with generally simple combinations of two options as in collars, to more troublesome straddle and strangle trades. Further developed strategies incorporate four options of two unique types, for example, a iron condor spread. These can additionally sharpen the risk and reward profiles to profit from additional specific changes in the underlying asset's price, for example, a low-volatility range-bound move.
The primary disadvantage of these complex strategies is increased commission costs. Any trader should comprehend their representative's commission structure to see whether it is helpful for trading combinations.
A few combinations are consistently utilized by options market makers and other professional traders in light of the fact that the trades can be developed to capture risk premiums while protecting their own capital from broad risk.
For any given underlying asset, the individual trader, commercial market maker, or institutional investor probably has two principal goals. One goal is to estimate on the future movement of the asset's price (whether higher, lower, or that it remains something very similar). The subsequent goal is to limit losses to a defined amount where conceivable. Risk protection comes at the cost of likely reward, either by capping that reward or having a higher cost in premiums and commissions from the extra options included.
Illustration of a Combination
To delineate the concept of a combination it is valuable to inspect the construction of a model trade. The following illustration of a iron butterfly trade shows how this combination of four option contracts meets up to form a single strategy, specifically, catching profit from a stock that doesn't move outside a given range.
The investor utilizing this combination accepts that the price of the underlying asset will stay inside a narrow range until the options terminate. The iron butterfly is an incredible guide to show the full range of combinations conceivable on the grounds that it comprises of two additional direct combinations set inside the more complex butterfly structure. Specifically, it is a combination of two vertical spreads of varying types: a bull put spread and a bear call spread. These spreads could possibly share a central strike price.
An iron butterfly is a short options strategy made with four options comprising of two puts, two calls, and three strike prices, all with a similar expiration date. Its goal is to profit from low volatility in the underlying asset. As such, it acquires the maximum profit when the underlying asset closes at the middle strike price at expiration.
The iron butterfly strategy has limited upside and downside risk in light of the fact that the high and low strike options, the wings, safeguard against critical moves in one or the other bearing. Due to this limited risk, its profit potential is additionally limited. The commission to place this trade can be an eminent element here, as there are four options included, which will increase the fees.
Highlights
- Combinations offer carefully tailored strategies for specific market conditions.
- Combinations are option trades developed from different contracts of varying options.
- These trades can have a wide assortment of strategies including extracting profit from up, down, or sideways trends in the market.
