Description
The Short Combo is a combination strategy involving selling a put option and selling a call option on the same underlying asset with the same expiration date but different strike prices. It can be considered a variation of a short strangle but tailored to capture income by selling both sides of the market.
Objective
Income Play: This strategy is typically used to generate income by selling options and collecting premiums.
Directional Play: It is a neutral or moderately bearish strategy. Traders expect little movement in the underlying asset’s price.
Volatility Play: The strategy profits from low volatility and the decay of time value of options.
Neutral: It works best in markets where the underlying asset’s price remains relatively stable.
Market View
Bullish/Bearish/Neutral: Generally neutral to moderately bearish. Traders using this strategy hope the underlying asset will stay within a range.
High IV: The strategy works well in high implied volatility environments, as option premiums are higher.
When to Use
Market Condition Cues: Use the Short Combo when the market is expected to show little movement, or the asset price is expected to stay within a defined range. It works best when implied volatility is high, allowing for higher premiums to be collected.
Instruments Used
Index Options: Short combo can be applied to index options, where broader market movements are anticipated.
Stock Options: Can also be used on individual stocks when the market view is neutral or slightly bearish.
Risk Profile
Limited/Unlimited/Neutral Risk: This strategy has a neutral risk profile. The risk is limited to the premiums received minus any margin requirements. Losses can be substantial if the underlying asset moves significantly in either direction.
Capital Required
Approx. Margin/Deployment: The capital required is the margin requirement to sell the call and put options. This will depend on the volatility of the underlying asset, the strike prices chosen, and the number of contracts sold.
Setup
Entry Example:
Choose an underlying asset with high volatility.
Sell a call option at a higher strike price and a put option at a lower strike price, both with the same expiration date.
Example: Sell a call option at a strike of ₹500 and a put option at ₹450, both expiring in 30 days.
The number of contracts should be based on capital and risk tolerance.
How They Work and How to Use Them in Options Trading
The Short Combo strategy is a market-neutral or mildly bearish strategy where the trader sells both a call and a put option on the same underlying asset. The premium received from the two options is collected upfront. The position will generate profit if the underlying asset stays within a certain range.
ATM (At the Money):
Selling options with strikes closest to the current underlying price.
This provides a higher premium but also higher risk due to the greater chance of the options becoming in-the-money.
OTM (Out of the Money):
Selling options with strikes further away from the current underlying price.
This offers lower premiums, but the likelihood of the options expiring worthless increases.
ITM (In the Money):
Selling options where the strike price is already profitable relative to the market price.
Higher premium income but increased risk if the price moves further in-the-money.
Steps to Trading with ATM, OTM, ITM
Select the Asset: Choose an underlying asset you believe will stay within a specific price range.
Select Expiry and Strike Price:
For ATM: Strike price closest to the current market price.
For OTM: Strike prices further from the current price, providing a greater chance of the options expiring worthless.
For ITM: Strike prices closer to or beyond the market price.
Monitor Position: Keep an eye on the price movement to ensure it remains within the desired range.
Context
Outlook: This strategy is suitable for a neutral outlook on the underlying asset. The trader expects little or no movement and wants to capitalize on time decay and premiums.
Rationale: Traders use this strategy to take advantage of options selling in a low-volatility environment. It works best when implied volatility is high.
Net Position: The trader holds a net short position in both call and put options.
Effect of Time Decay: Since the options are sold, time decay works in favor of the trader, causing the options’ extrinsic value to decrease as expiration nears.
Appropriate Time Period to Trade: Short combo works best when there is less expected volatility, and the trader believes the underlying asset will not experience major price movements in the near term.
Selecting the Option: Strike prices should be selected based on the anticipated range of the underlying asset. For a neutral view, select strikes that are outside the current price range but still within reach of normal market fluctuations.
Greeks
Delta: The delta of a short combo strategy is typically close to zero, as both the long call and long put position will offset each other. However, large price movements can shift the delta.
Gamma: Gamma will be higher in positions with ATM options as they are more likely to experience large price shifts.
Theta: Theta is positive, as time decay works in favor of the seller. The positions will lose value as time passes, providing profit to the trader.
Vega: Vega is negative for the short combo, as implied volatility increases, so does the price of options, leading to potential losses if volatility spikes.
Break-even Points
The break-even points are the strike prices of the sold options plus the net premium received. If the underlying asset’s price is between the two break-even points, the strategy is profitable.
Maximum Profit
The maximum profit is equal to the total premium collected for the call and put options sold, minus any transaction fees.
Maximum Loss
The maximum loss is theoretically unlimited if the price moves far beyond the strike prices of the sold options. However, this is unlikely unless the underlying asset experiences significant price swings.
Risk and Reward Ratio
The risk-reward ratio depends on the premiums collected and the distance between the strike prices. Typically, this strategy has a favorable reward to risk ratio if the asset remains within a defined range.
Advantages and Disadvantages
Advantages:
Income Generation: The strategy generates immediate premium income.
Works in Range-bound Markets: It is beneficial when the market is not expected to move drastically.
Time Decay Works in Favor: Time decay reduces the value of the sold options over time.
Disadvantages:
Unlimited Risk: In extreme cases, this strategy exposes the trader to unlimited risk if the price moves significantly away from the strike prices.
Requires Close Monitoring: The position needs constant monitoring to ensure the underlying asset remains within the desired range.
Exiting the Trade
Exiting the Position: The trade can be exited by buying back the sold options before expiration. This is often done if the market moves too far in one direction, or if time decay has taken its toll.
Mitigating a Loss: In case of a significant move, the trader may roll the options to further expiration or adjust the strike prices to mitigate losses.
Maximum Profit and Maximum Loss
Maximum Profit: The maximum profit is limited to the premium received for the call and put options sold.
Maximum Loss: Theoretically unlimited loss if the price moves significantly in either direction. The risk is higher than a standard short strangle due to the neutral outlook and volatility factors.
Are These Profitable and Risky Strategies?
Profitable: The strategy is profitable when the underlying asset remains within a specified range and time decay erodes the value of the sold options.
Risky: This strategy can be risky if the market moves drastically in one direction or another, as losses can be substantial.
Payoff Diagram
Strategy Setup
Sell ATM Call @ 24,400 for ₹100
Sell ATM Put @ 24,400 for ₹100
Net Credit = ₹200
Payoff Explanation at Expiry
If NIFTY closes at 24,400:
Both options expire worthless
Max Profit = ₹200
If NIFTY rises above 24,400:
Call incurs loss
Put expires worthless
Loss increases as NIFTY rises
If NIFTY falls below 24,400:
Put incurs loss
Call expires worthless
Loss increases as NIFTY falls
Adjustments
Early Exits: If the price moves quickly, the position may need to be closed early to limit losses.
Rollovers: The position can be rolled to further expiration dates if market conditions change.
Shift Strikes: If the market shifts, you may need to adjust the strikes to reflect new expectations.
Tax Implications
The tax treatment for options trading can vary depending on the country and type of trade. Generally, the premiums received are considered income, and taxes may apply based on short-term or long-term capital gains rules.
Backtest / Stats
Backtesting this strategy involves analyzing historical data to assess the probability of the underlying asset remaining within a specific price range at expiration. Statistics such as win rate and average profit/loss per trade are useful.
Notes / Insights
The Short Combo strategy works best in low-volatility markets, where large price movements are unlikely. It requires close monitoring of the market and proper risk management to avoid significant losses. The key is to select the right strike prices and expiration dates based on your market view.
The Bottom Line
The Short Combo is a market-neutral strategy that can be profitable in stable or low-volatility markets. It generates income from selling options but carries significant risk if the price moves dramatically in either direction. Properly managing risk, adjusting positions, and monitoring the market are crucial to success with this strategy.
