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Combination

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A Combination simultaneously purchase one kind of option while selling another option at the same strike price. Long combinations synthetically create a position which emulates owning an underlying asset. Short combinations emulate short selling an underlying asset.

Long Combination

 Long Combination

How To Read/Interpret Option Diagram
A long combination buys a call and sells a put, and should only be used when underlying assets are expected to rise in price. The long call gives the right to purchase the underlying asset above the strike price. The short put obligates the sale of the underlying asset underneath the strike price. There is heavy risk if the underlying price falls, but substantial amounts of reward if the price rises.

The price of entering a long combination is substantially reduced compared to buying a long share. The sold put helps pay for the purchased call. This opens a similar, but potentially accelerated, risk-reward profile for a lower cost. The sale of the put will place a margin requirement on the combination position. The potential profit is unlimited as long as the share price continues to rise.

The amount paid to open the position depends on the relationship between the underlying price and the shared strike price. If the call purchased costs more than the put sold, you will pay to open the position. If the put sold is worth more than the call purchased, you will receive a payment to open the position. If the underlying price is above the strike price you’re more likely to pay a net debit, if it’s below the strike price you are more likely to receive a credit.

Short Combination

 Short Combination

How To Read/Interpret Option Diagram
A short combination buys a put and sells a call, and should only be used when underlying assets are expected to fall in price. The long put gives the right to sell the underlying asset below the strike price. The short call obligates the sale of the underlying asset above the strike price. There is heavy risk if the underlying price rises, but substantial amounts of reward if the price falls.

The price of entering a short combination differs in comparison to short selling an asset. The sold call helps pay for the purchased put, but you may require an initial outlay for the position. This opens a similar, but potentially accelerated, risk-reward profile to a short sale. The sale of the call will place a margin requirement on the combination position. The potential loss is unlimited as long as the share price continues to rise.

The amount paid to open the position depends on the relationship between the share price and the shared strike price. If the put purchased costs more than the call sold, you will pay to open the position. If the call sold is worth more than the put purchased, you will receive a payment to open the position. If the underlying price is below the strike price you’re more likely to pay a net debit, if it’s above the strike price you are more likely to receive a credit.

Dividends

Ex-Dividend dates strongly affect the value of both long and short combinations. The underlying share price usually falls by the dividend value after an ex-dividend date. An anticipated dividend can affect call and put values, and thus whether any combination has a net debit or a net credit.

Implied Volatility & Time Decay

The selling and buying of differing options types at the same strike prices reduce the overall effects of both implied volatility and time decay, as long as both options are held at the same time. Closing half of the position exposes time value or implied volatility, depending whether you are holding the long side or the short side.

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Option Profit Diagram Example

  • As you move to the right the underlying asset increases in value. The left side is lower in underlying price, while the right side is higher in underlying price.
  • As you move to the top the trade increases in profit. The gray horizontal line is the profit/loss difference point, the zero line where there is no profit and no loss. Higher above the line is higher in profit, lower below the line is higher in losses.
  • The blue line is the profit/loss at expiration. The purple line is the profit/loss now. Eventually the curving purple line will become the blue line.
  • A flat blue line below the grey zero line indicates limited losses at expiration. A flat blue line above the grey zero line indicates limited gains at expiration. A blue line that slopes down infinitely off the chart represents unlimited losses, while a line that slopes infinitely up represents unlimited gains.
  • A preference for limited loss trades is strongly recommended, remember that an estimated 60% to 70% of retail trader options expire worthless when purchased since prices need a reason to move in the money. If you have limited gains, they should preferably be both more likely than and higher than your potential losses. Always manage risk carefully.
  • Option diagrams created by TDAmeritrade “ThinkOrSwim” platform.