Combinations
Combinations are similar to straddles, but the expiration dates and/or the strike prices of the two options are different.
Let’s refresh ourselves on what a straddle looks like:
Long 1 ABC Jan 70 call
Long 1 ABC Jan 70 put
Long straddles contain two long options (call and put) with the same expiration and strike price. With one small change, it can become a long combination:
Long 1 ABC Jan 80 call
Long 1 ABC Jan 70 put
The strategy is no longer a straddle because there’s a difference in the strike prices. It’s officially a combination. A long combination could also look like this:
Long 1 ABC Jan 70 call
Long 1 ABC Feb 70 put
Here, the difference in the expirations also makes it a combination. Last, the long combination could also take this form:
Long 1 ABC Jan 80 call
Long 1 ABC Feb 70 put
When both the strike prices and the expirations are different, it’s also a combination. Bottom line - if it looks like a straddle, but there’s a difference in the strikes, expirations, or both, it’s a combination.
Long straddles profit in volatile markets and lose in flat markets. The investor makes a return as long as the call or put makes more money than the combined premiums paid upfront. Long combinations are similar.
Let’s take a look at some math-based combination questions:
An investor goes long 1 ABC Jan 80 call at $3 and long 1 ABC Jan 70 put at $2 when ABC"s market price is $75. What is the maximum gain?
Can you figure it out?
Maximum gain = unlimited
Like a long straddle, the long call is eligible for unlimited returns when the market rises. The put will expire in this scenario, but the call makes a larger return as ABC’s market price increases. The contract provides the right to buy ABC shares at $80. The further the market rises, the higher the investor can sell the stock.
How about maximum loss?
An investor goes long 1 ABC Jan 80 call at $3 and long 1 ABC Jan 70 put at $2 when the market price is $75. What is the maximum loss?
Maximum loss = $500 (premiums)
Like a long straddle, the most the investor can lose are the combined premiums, which occurs when the market is flat. The big difference is the “spread” where the investor experiences the maximum loss.
Long straddles realize the maximum loss when the market price is at the shared strike price. Both options are “at the money” and have no intrinsic value when this occurs. Remember, if options are “at the money” or “out the money” at expiration, they expire.
In the question above, both options will expire if ABC’s market price stays at or between $70 and $80. The put goes “in the money” (gains intrinsic value) when ABC’s market price falls below $70, while the call goes “in the money” when it rises above $80.
Bottom line - the investor has a broader range of risk with a combination like this, as it’s much easier for both options to expire.
Before we move on to the next question, this combination is known as a strangle. A strangle is a combination where both options (long or short) are “out of the money” (have no intrinsic value).
Let’s look at the strategy again:
Long 1 ABC Jan 80 call @ $3
Long 1 ABC Jan 70 put @ $2
Market price = $75
At $75, neither option has intrinsic value, and both are “out of the money.” If the market stays at $75, the call expires worthless. Why would the investor exercise and buy shares at $80? Also, the put expires worthless. Why would the investor exercise and sell shares at $70?
A strangle is sometimes called a “cheap person’s straddle.” If the investor bought the call and put with a shared $75 strike price (creating a long straddle), the strategy would’ve been more expensive (higher premiums on both options). However, it would’ve been easier for either side to gain intrinsic value. This is a prime example of the “push and pull” of finance. A straddle is more expensive than a strangle, but it’s easier for either leg to be “exercisable.”
Let’s look at breaking even.
An investor goes long 1 ABC Jan 80 call at $3 and long 1 ABC Jan 70 put at $2 when ABC’s market price is $75. What is the breakeven?
Breakevens = $65 and $85
Like straddles, combinations have two breakevens. This should make sense, as the investor can make a return if the market rises or falls.
The investor must make back the combined $500 premium paid upfront to break even. If ABC’s market price falls to $65, the investor’s put is “in the money.” They can go to the market, buy shares at $65, exercise the put, and sell them for $70. This locks in a $5 per share gain, or $500 overall, offsetting the original premium paid.
If ABC’s market price rises to $85, the investor’s call is “in the money.” They can exercise the call, buy shares at $80, and then sell them in the market at $85. This locks in a $5 per share gain, or $500 overall, offsetting the original premium paid.
To find the breakevens on a combination, first, add up the premiums. Next, subtract the combined premium from the put’s strike price ($70 - $5 = $65), then add the combined premium to the call’s strike price ($80 + $5 = $85.
Let’s look at the options payoff chart to summarize the “big picture” of this long combination. First, let’s re-establish the example:
Long 1 ABC Jan 70 put @ $2
Long 1 ABC Jan 80 call @ $3
Here’s the payoff chart:
The horizontal axis represents the market price of ABC stock, while the vertical axis represents overall gain or loss.
As the long combination payoff chart shows, the investor reaches their maximum loss of $500 when the market price is between $70 and $80. Both options expire worthless in this range, and the combined premium represents the overall loss. If the market price rises above $80 or falls below $70, the call or the put goes “in the money” and gains intrinsic value.
If the market price rises to $85, the long call gains $5 of intrinsic value, offsetting the combined premiums. Any market price above $85 results in profit as the investor is eligible for unlimited gain potential. If the market price falls to $65, the long put gains $5 of intrinsic value, offsetting the combined premiums. Any market price below $65 results in profit as the investor is eligible for up to $6,500 of gain potential (a $6,500 gain would occur if the market price falls to $0).
Let’s move on to short combinations.
Short straddles profit in flat markets and lose in volatile markets. If the market rises or falls too far, the assignment (exercise) losses could be more than the combined premiums received upfront. Short combinations are similar.
Let’s go through some short combination questions.
An investor goes short 1 ABC Jan 40 call at $4 and short 1 ABC Jan 30 put at $3 when ABC’s market price is $35. What is the maximum gain?
Maximum gain = $700 (premiums)
Like a short straddle (and any other short option strategy), the premiums are the maximum gain. If both options expire worthless, the investor keeps the combined premiums and is not forced to fulfill either obligation.
Compared to a short straddle, this short combination maintains a larger “spread” where the maximum gain occurs. For both options to expire on a short straddle, the market price must be the same as the shared strike price. This rarely occurs.
This short combination has more “wiggle room” for the maximum gain. If ABC’s market price stays at or above $30, the put expires worthless. If ABC’s market price stays at or below $40, the call expires worthless. As long as the market price stays at or between $30 and $40, both options expire, resulting in the maximum gain.
How about the maximum loss?
An investor goes short 1 ABC Jan 40 call at $4 and short 1 ABC Jan 30 put at $3 when ABC’s market price is $35. What is the maximum loss?
Maximum loss = unlimited
Short straddles and short combinations both have unlimited risk potential due to the short (naked) call.
When ABC’s market price rises above the call’s strike price, it goes “in the money” and gains intrinsic value (“call up”). The call will be assigned (exercised), forcing the investor to sell shares at $40. The investor does not currently own the shares, so they must go to the market to purchase them (for delivery at exercise). The further the market rises, the more expensive those shares are, and the more the investor loses.
The investor can also lose a considerable amount of money on the short put if the market falls drastically, but the short call’s unlimited loss potential is the most significant.
For our last question, let’s look at breaking even.
An investor goes short 1 ABC Jan 40 call at $4 and short 1 ABC Jan 30 put at $3 when ABC’s market price is $35. What is the breakeven?
Breakevens = $23 and $47
As we learned earlier with long combinations, short combinations also have two breakevens. With short combinations, the investor must lose the combined premium received upfront to break even.
If ABC’s market price falls to $23, the investor’s put is “in the money,” which is not optimal for the investor. The put will be assigned, obligating a purchase of ABC shares at $30. Those shares are only worth $23, resulting in a $7 loss or $700 overall ($7 x 100 shares). The assignment losses completely offset the combined premiums received upfront.
If ABC’s market price rises to $47, the investor’s call is “in the money.” The call will be assigned, obligating a sale of ABC shares at $40. Before the sale occurs, the investor must go to the market and purchase the shares at the $47 market price, locking in a $7 loss or $700 overall ($7 x 100 shares). The assignment losses completely offset the combined premiums received upfront.
To find the breakevens on a combination (long or short), first, add up the premiums. Next, subtract the combined premiums from the put’s strike price ($30 - $7 = $23), then add the combined premiums to the call’s strike price ($40 + $7 = $47).
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