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What is a Short Combination

12 Jul 2023

In the stock market, bear cycles can strike causing prices to plummet and investors to suffer losses. However, armed with knowledge, savvy investors turn to derivatives and leverage strategies like a Short Combination.

They diversify and employ these powerful tools to navigate the challenges of a bear market, protecting their capital and potentially even gaining profit. 

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In this blog, we will delve into a Short Combination concept, exploring its secrets and empowering you to make informed decisions in the world of options trading. 

What are the Options?

If you want to understand the concept of short combinations, you need to learn about options first. 

A financial agreement that gives the holder the right, but not the obligation, to purchase or sell an underlying asset at a fixed price in the future is known as an option. Call Options and Put options are the two types of Options in this market. While Call Options provide the right to buy the asset, Put Options give the right to sell it. 

What is a Short Combination?

A short combination is a dynamic options strategy involving simultaneously selling a call option and a put option. It serves as the inverse of a long combination, with the trader selling call options at a higher strike price while buying put options at a lower strike price. This synthetic strategy mimics a scenario of selling shares, which makes it a popular bearish approach in options trading. 

Typically combined with other strategies, the short combination offers short-term opportunities and the potential to earn a net credit investment during upward movements in share prices. 

How Does Short Combination Work?

The short combination options strategy operates on the concept of net credit. Traders receive a net credit while initiating this strategy. However, they have to fulfil additional margin requirements due to the short call. 

If the position is held until expiry, the trader will need to sell the stock. If the stock price exceeds the strike price, the call option is realised, resulting in short selling. Simultaneously, if the stock price is below the strike price, the put option is exercised to sell the stock. While the maximum profit is limited to the initial premium difference, the potential loss can be unlimited.

Let’s learn the concept of short combination with the help of an example: 

ABC stock is trading at Rs. 30. Ms Rao, a trader, decides to implement a short combination strategy by purchasing a long put option with a strike price of Rs. 25, a premium of Rs. 0.85, and a three-month expiration. 

Simultaneously, she sells a short call option with a strike price of Rs. 35, a premium of Rs. 1, and the same expiration period. This setup results in a net credit of Rs. 0.15. The maximum profit potential is Rs. 25.15, while the break-even point stands at Rs. 35.15. 

Through this short combination options strategy, the trader can potentially earn profits based on this setup. 

What are the Pros and cons of Short Combination?

Pros:

The benefits of a Short Combination are:

  1. Theoretically, the profit is unlimited (limited in practice due to a share price floor).
  2. Similar to a regular short position but with minimal cost. 

Cons: 

The limitations of a Short Combination are:

  1. A high Bid/Offer Spread negatively impacts the position.
  2. The potential loss is unlimited in a rising share price scenario. 

Conclusion

The short combination strategy presents an option strategy suitable for a bearish market outlook. Traders can potentially secure profits by capitalising on the decline in the underlying asset’s price. Moreover, the short call option position can offset or even cover the cost of the long put option, effectively reducing the overall strategy cost. 

However, it is essential to be cautious when trading this strategy, as it involves selling or writing options. Careful considerations and risk management are essential to navigate the potential risks and rewards associated with the short combination strategy. 

 

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