What is a Short Combination?

Are you curious about exciting options trading strategies that experienced traders use to profit in specific market conditions? If so, you should learn about the short combination strategy. 

In this article, you’ll discover what a short combination is and how it works, and get an example based on Indian stocks. 

What are the options?

Options are agreements that allow someone to purchase or sell something at a specific price in the future. There are two main types of options, but the critical thing to know is that they give you the right to buy or sell something without requiring you to do so.

• Call options – Allow buyers to buy the underlying asset
• Put options – Allow buyers to sell the underlying asset

To acquire an options contract, buyers have to pay premiums to sellers. However, buyers are not obligated to exercise the options if it does not make financial sense.

Key options terminology

Now that we know what options are let’s go through some key terminology before moving forward:

1. Strike price: The fixed price at which buyers can trade the underlying asset if they exercise the option.

2. Expiration date: The last date buyers can exercise their options.

3. In-the-money: When the underlying asset’s current market price is above the call option’s strike price or below the put option’s strike price.

4. Out-of-the-money: When the underlying asset’s current market price is below the call option’s strike price or above the put option’s strike price. 

5. Premiums: The upfront fee options buyers pay to sellers to acquire the options contracts.

What is a short combination?

A short combination is a strategy used in the stock market that can help traders mimic the profit they would make if they sold shares of a stock they don’t own. Instead of borrowing and selling shares, the trader sells two options: a call option and a put option. 

This strategy involves selling the call option at a higher price and the put option at a lower price. Using this strategy, traders can profit if the stock price stays within a designated range. This combination produces a net credit for the trader when initiating the trade. The strategy aims to profit from sideways or bearish moves in the underlying stock.

Traders utilise short combinations when they have a neutral to bearish bias on a stock in the near term. By implementing this strategy, they collect premium income upfront without needing to tie up much capital. The risk is that the stock makes a solid bullish move, which could lead to unlimited losses. Appropriate position sizing and risk management are essential.

How does a short combination work?

When initiating a short combination, the trader sells one call option and one put option simultaneously. By selling the call option, they must sell the underlying stock at the coordinated strike price if given. By selling the put, they must buy the underlying stock at the agreed put strike if assigned. 

The call strike is higher than the stock’s current market price, while the put strike is lower. This difference in strikes allows the trader to collect an initial net credit. However, additional margin requirements must be met because a short call is involved.

As expiration approaches, there are a few possible outcomes:

1. If the stock expires below the put strike, the put buyer will not exercise the option since they can obtain the stock cheaper in the market. The put expires worthless while the trader keeps the premium. 

2. If the stock expires between the put and call strikes near expiration, both options expire worthless. The trader pockets the full initial credit.

3. The trader may be assigned to that short call option if the stock rallies above the call strike. They would then be obligated to sell the stock at the call strike price, even if much higher. The maximum loss is unlimited in a rally.

In summary, the short combination strategy earns the net initial credit received upfront. It profits from a sideways market or a drop in the underlying stock price. However, sharp upside rallies can lead to significant losses.

Example of a short combination in Indian stocks 

Let’s walk through an example of constructing a short combination using options on Reliance Industries Ltd (RIL).

Suppose RIL shares are currently trading at ₹2430. A trader initiates a short combination by selling 1 RIL 2400 put for ₹20 and selling 1 RIL 2500 call for ₹25. 

The net credit received upfront is ₹25 – ₹20 = ₹5 per share. This net credit represents the maximum profit potential on the trade.

Here is how the P&L graph looks at expiration across various closing prices of RIL stock:

• Below 2400: Put expires worthless, the trader keeps ₹5 credit – Max profit.
• Between 2400-2500: Both options expire worthless, and the trader keeps ₹5 credit.  
• Above 2500: Call is assigned, the trader sells stock at 2500 – Loss starts accumulating above 2500

As long as RIL closes between ₹2400-2500 at expiration, the trader pockets the ₹5 credit. This range defines the profit zone of the short combination strategy.

However, if RIL makes a robust bullish move above ₹2500, losses can accumulate quickly due to the short-call option. Appropriate risk management is vital, likely involving early exit of the position to cap losses.

The short combination allows the trader to collect premium income in neutral to moderately bearish scenarios on the stock. But runners in the stock can lead to substantial losses – a risk that must be planned for.

Using short combinations efficiently

A short combination involves selling a call option at a higher strike and a put option at a lower strike to generate an initial net credit. It has limited profit potential capped by the initial credit, with maximum losses if the underlying stock surges above the call strike at expiration.

Traders employ short combinations when they expect muted action or a stock price dip soon. Risk and reward profiles must be clearly defined, and prudent position sizing is critical.

By mastering market conditions suitable for short combinations and managing risks, traders can collect periodic premium income from Indian stock options using this strategy. However, as with all options strategies, continuous education and experience are vital for long-term success.

Conclusion

The short combination strategy is a way to make money by selling both calls and put options. It works best when the underlying asset’s price finishes between two specific prices at a particular time in the future. But it’s essential to be careful because there are risks involved. If done correctly, this strategy can provide a steady source of income.

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