Combination trades take advantage of the correlation between two different assets. If you wanted to make a long trade but weren’t sure which commodity or currency you wanted to invest in, it may be beneficial for you to make a combination trade.
Combination trades are a type of trade where an investor simultaneously buys and sells two or more options contracts of the same kind with different strike prices and expiration dates. The goal is to profit from a move in the underlying security, regardless of the direction. Saxo Bank offers opportunities to use combination trades; you can visit their website here.
There Are Two Types of Combination Trades
Bull Put Spread
A bull put spread is created when an investor buys a put option with a lower strike price and sells another put option at a higher strike price. If the underlying security moves higher, this trade profits but remains below the higher strike price.
Bear Call Spread
A bear call spread is created when an investor buys a call option with a higher strike price and sells another call option at a lower strike price. If the underlying security moves lower, this trade profits but remains above the lower strike price.
For both of these combined option trades, there are two potential outcomes when the options expire: either they expire worthless, or you receive an amount that is very close to what you paid for them when you purchased them. Therefore, combination trades require less out-of-pocket capital than buying just one option contract by itself.
Combination Trading Example
A bull put spread on stock XYZ:
Stock XYZ’s current price is $50, and you expect it to increase over time. You can buy a call option with a 55 strike price for $4 per share ($400 total cost). Or, if you think it will remain flat or fall, you can buy a put option with a 50 strike price for $2 per share ($200 total cost).
Instead of buying both options individually, you could create a combination trade by selling the call option with the 55 strike price and write the put option with the 50 strike price. This would give you an out-of-pocket expense of approximately -($200) because you are receiving money from writing the put contract. If, at expiration, both contracts are in-the-money, then instead of making or losing additional cash on top of your initial investment, your broker will liquidate your position at market prices. Therefore, if XYZ is trading more significantly than $55 per share ($4.00 call premium + $50 stock price ), you will have a loss from the put option being in the money ($2 per share). However, your gain from the long call option would add to this.
Alternatively, if XYZ is trading for less than $50 per share ($4.00 call premium + $55 strike price), you would have a loss from the short call option being in-the-money ($4 per share). However, your gain from the long put option would offset this loss.
You could also buy one contract on either side (long or short) and sell an opposite contract (to reduce or increase your total risk exposure). If all goes well, by the time expiration arrives, both contracts expire out-of-the-money, and you made a small profit.
Combining bull put and bear call spreads can be a great way of achieving the perfect hedge for your portfolio. For example, you might have a long position on stock XYZ, and you are worried that it will fall soon, so you also buy an out-of-the-money put option with a strike price of 50 to protect against this occurrence. But if both contracts end up in the money at expiration, this trade presents additional risks (and costs) when closing out both positions. Combining these two trades into one single transaction reduces your risk. Instead of potential losses from having both open positions expire in the money, one side is left ‘intact’, which is beneficial because it can be closed without additional cost.