What is a Short Combination?

A basic principle in the stock market is the occurrence of both the market trends (Bear and Bull) at regular intervals. In the case of a bear cycle, the prices of the securities collapse, forcing investors to lose a chunk of their capital. However, with extensive knowledge of the stock market, these investors diversify and invest a portion of the capital in derivatives and leverage strategies such as Short Combination. However, to understand what is short combination, it is important to understand a type of derivative known as Options.

What are the Options?

An option is a financial contract that gives you the right but not the obligation to buy or sell an underlying asset at a predetermined price in the future. To enter into an option contract, you have to pay a premium, but you are not under any obligation to exercise the contract. There are two types of options contracts:

• Call Options: A Call Option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a specific price and date between the contracting parties.
• Put Options: A Put Option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the price on the date agreed upon by the contracting parties.

However, as the short combination is an options strategy, there are some terms you must understand before you learn about the short combination:

• Strike Price: The price at which the options contract was initially bought or the pre-determined price.
• Spot Price: The current price of the underlying asset is attached to the options contract.
• Premium: It is the price you pay to the seller of the option for entering into the online trading options.
• In-The-Money (ITM) option: When the underlying asset price is higher than the strike price.
• Out-of-the-money (OTM) option: When the underlying asset price is lower than the strike price.

What is a Short Combination?

A short combination is an options strategy that entails the sale of a call option and a put option simultaneously. The short combination is the opposite of the long combination and requires the trader to buy put options at a lower strike price and sell call options at a higher strike price. The short combination is called a synthetic strategy as it simulates a share-selling situation in the market. The short combination options strategy is short-term and is most commonly combined with other options trading strategies. This strategy is bearish and allows traders to earn a net credit investment when the share prices are increasing.

How does a Short Combination work?

The short combination options strategy works on the principle of net credit. When the short combination options strategy is initiated, the trader receives a net credit. However, because of the short call, the traders are asked for additional margin requirements in their accounts. If the traders do not close the position until the expiry, the trader will have to sell the stock one way or the other. In case the stock’s price is higher than the strike price, the call option is realized and results in short selling of the stock. However, if the stock price is lower than the strike price, the trader exercises the put option to sell the stock.

Example of Short Combination

The maximum profit a trader can earn from a short combination options strategy is the difference between the premium earned and paid initially for the options. However, the maximum loss potential is unlimited. Here is an example of a short combination for better understanding:

XYZ is trading at Rs 35 and the trader buys a long put option with a strike price of Rs 30, a premium of Rs 0.90, and an expiration date of three months. Simultaneously, the trader sells a short call option with a strike price of Rs 40, a premium of Rs 1, and an expiration date of three months. By executing the short combination options strategy, the trader will earn through the following setup:

Net Credit: Rs 1- 0.90 = Rs 0.10
Maximum Profit: Rs 30 + 0.10 = Rs 30.10
Break Even Point: Rs 40 + 0.10 = Rs 40.10

Final Word

The short combination options strategy allows traders to earn profits if the short call option expires in the money and the short put options ensure that the trader earns a profit if it expires at the money or out-of-the-money. However, if the market becomes volatile, the trader may lose money with the same amount by which the options contract is in the money. Hence, it is wise that you do extensive market research before executing a short combination options strategy.