What is a Short Combination?

A short combination is a strategy investors use to maximise profit opportunities, while minimising risk. This is achieved by helping traders capitalise on price movements and protecting them from unpredictable market conditions. This article explains what a short combination is, how it works, its advantages and risks, and practical examples to understand its application in the Indian market.

The Basics of Short Combination Strategy

A short combination is an options trading strategy where a trader sells both a call and a put option with the same strike price and expiration date. This strategy works best when the trader expects little price movement in the underlying asset. The goal is to profit from the premiums received for selling both options.

Since selling a call obligates the trader to sell the stock and selling a put obligates them to buy it, the strategy behaves like a short stock position. However, instead of borrowing and selling the stock, the trader uses options to achieve a similar effect.

How Does a Short Combination Work?

A trader who initiates a short combination sells:

• A call option: This gives the buyer the right to purchase the asset at the strike price.
• A put option: This gives the buyer the right to sell the asset at the strike price.

By selling both options, the trader collects the premium from both transactions. However, if the underlying asset’s price moves significantly in either direction, the trader faces unlimited risk.

Example of a Short Combination in Rupees

Let’s assume a trader decides to use a short combination on XYZ Ltd., a stock currently trading at ₹500 per share. The trader sells:

• A call option with a strike price of ₹500 at a premium of ₹20 per share.
• A put option with a strike price of ₹500 at a premium of ₹20 per share.

Since both options are sold, the trader collects a total premium of ₹40 per share (₹20 + ₹20). If the stock price remains near ₹500 until expiration, the trader earns a total of ₹40 per share.

However, if the stock price moves significantly, the trader may face a loss:

• If XYZ Ltd. rises to ₹600, the trader will have to sell the stock at ₹500, incurring a loss of ₹100 per share (₹600 – ₹500), minus the ₹40 premium collected.
• If XYZ Ltd. falls to ₹400, the trader will have to buy the stock at ₹500, again incurring a loss of ₹100 per share, minus the ₹40 premium collected.

Thus, a significant price movement in either direction can lead to heavy losses.

Why Do Traders Use Short Combinations?

Traders employ the short combination strategy for several reasons:

1. Profit from Stability: If the underlying asset remains near the strike price, the trader profits from the premium received.
2. Lower Initial Investment: Unlike stock trading, selling options does not require the full stock price, making it a capital-efficient strategy.
3. Flexibility: This strategy allows traders to benefit from options without taking a direct position in the stock.
4. High Probability of Small Gains: Traders can repeatedly earn premium income if the stock does not move much.

Risks of a Short Combination

While the short combination can be profitable, it comes with significant risks:

1. Unlimited Loss Potential: If the price moves significantly up or down, losses can be large because there is no limit to how much a stock can rise or fall.
2. Margin Requirements: Since the strategy involves selling options, brokers may require a high margin, which can be costly for retail traders.
3. Volatility Risk: Unexpected market movements due to news, economic events, or earnings announcements can lead to heavy losses.
4. Assignment Risk: If the options are exercised early, the trader may be forced to buy or sell shares at an unfavourable price.
5. Time Decay Factor: While traders benefit from collecting premiums, rapid price movements can cause unexpected losses.
6. Liquidity Constraints: Certain option contracts may have low trading volume, leading to challenges in executing trades at favourable prices.

When to Use a Short Combination?

A short combination is best used when:

• The trader expects the stock price to remain stable.
• The market volatility is low, reducing the likelihood of large price swings.
• The trader has sufficient capital to cover potential margin requirements.
• The trader is experienced in handling risk management.
• The trader is willing to monitor the position closely to react to sudden market changes.

Alternative Strategies to Consider

If the risk associated with a short combination appears too high, traders can explore alternative strategies to manage potential exposure:

• Short Straddle: This approach entails selling both a call and put option at the same strike price, anticipating minimal market volatility.
• Short Strangle: Similar to a short combination, but the call and put options have different strike prices, reducing risk while maintaining a potential profit margin.
• Covered Call: Involves selling a call option while holding the underlying stock. This strategy allows traders to generate premium income while providing limited downside protection.
• Protective Put: This hedging strategy includes purchasing a put option to safeguard against possible declines in stock value, minimising potential losses.

Conclusion

The short-combination represents a volatile yet potentially effective options trading strategy used for making profits in a stable market. When traders sell both a call and a put at the same strike price, they collect premiums but expose themselves to unlimited risk if the market moves significantly one way or the other.

Although one can make money with this strategy in a low-volatility environment, risk management becomes critical, and so does sufficient capital to cover margin requirements. Traders should be cautious about fully exposing themselves to the risks of a short combination and instead opt for safer strategies.