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Market Structure

Options strategies (part 2)

June 16, 2021

Option combination strategies

Besides buying or selling single options, there are many other possible strategies that involve positions in multiple options simultaneously, as well as combining options with positions in the underlying assets. While there are infinite combinations possible, we outline three common combinations below.

Protective collar

A protective collar strategy is a combination of a protective put and a covered call strategy. The long put option protects the investor from a downward move in the underlying asset’s price, while writing a call option generates a premium that offsets (some) of the cost of buying the long put (though it also limits the upside potential). This combination can be used to lock in unrealized gains in the underlying asset  without having to sell the shares right away. If the underlying asset’s price declines, the position is insured against losses via the long put option. Conversely, if the price of the underlying asset increases beyond the strike price of the call options, it will be exercised, with the investor selling the shares and realizing any gains.

Long straddle

A long straddle involves buying a call and put option on the same underlying asset with the same strike price and expiration date. This strategy can be used by an investor that believes the price of the underlying asset will move significantly, but is unsure about the direction of the move. The maximum loss of the strategy is limited to the sum of the premiums paid for the call and the put options. The further away from the strike price that the price of the underlying asset moves, the higher the pay-off of the straddle.

Call spread/Put spread

A call spread (put spread) is a combination that involves buying and selling call (put) options with different strike prices, called a vertical spread, or different expiration dates, called a horizontal or calendar spread. Compared to buying single call or put options, these strategies have more limited profit potential, but they are also cheaper to enter into because of the option premium received from writing options. Based on the direction the investor thinks the price of the underlying asset will move, spreads can be constructed as bullish to benefit from price increases in the underlying assets or as bearish to benefit from price decreases or no move.

Examples

Bull spread

a bull spread with calls involves a combination of a long and short call option with the same expiry, where the strike price of the short call is higher than that of the long call. A bull spread with puts involves a long and short put option, where the strike price of the short put is higher than that of the long put. This strategy works well when an investor is bullish on the market direction and also has an exit level where they are happy to sell.

Bear spread

a bear spread with calls involves a combination of a long and short call option, where the strike price of the long call option is higher than that of the short call option. A bear spread with puts involves a long and short put option, where the strike price of the long put is higher than that of the short put. This strategy works well when an investor is bearish on the market direction.

Long calendar spread

this involves buying a call (put) option with a longer time to maturity and selling a call (put) option with a shorter time to maturity on the same underlying asset at the same strike price. This combination strategy can be used when the investor has a neutral short-term outlook on the underlying asset. The combination’s profit is maximized when the strike price equals the price of the underlying asset at maturity of the shorter term option. In that case, the shorter term option that is sold expires with no intrinsic value, while the longer term option that the investor holds has maximum time value.

Schematic pay-off at expiration of the shorter maturity option

Short calendar spread

this involves buying a call (put) option with a shorter time to maturity and selling a call (put) option with a longer time to maturity. This combination strategy can be used when the investor expects a big price change in the underlying asset, but is uncertain of the direction of the change. The combination’s profit is maximized when the price of the underlying asset is far from the strike price at maturity of the shorter term option.

Schematic pay-off at expiration of the shorter maturity option